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Section 1250 unrecaptured gain on installment contract = deferred and often permanently reduced tax obligation!

“My tax advisor says I have to take all the depreciation recapture the year I sell. Is this true?”

It depends. If you sell your rental real estate and get cashed out or if you have only owned the property for a year or two, then your tax advisor is correct.
However, if you sell on “installment contract” you can defer — and in many cases permanently reduce –your tax liability due to depreciation recapture and capital gain! The most incredible aspect of the installment contract method is that sellers only pay taxes on their current tax bracket. This could save you thousands in tax obligation permanently!

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Simply put, we work with you, the attorney, and a CPA to customize the right offer for your clients.

Tax Deferment With Section 1250 Unrecaptured Gain

Take a look below at correspondence from a CPA regarding tax deferment with section 1250 unrecaptured gain with installment contracts (fancy tax lingo for seller contract).

“We talked briefly on the telephone today, and you asked that I provide some clarification with regards to reporting under the installment method when selling real property at a gain. (For authoritative guidance: IRC Sec 453 and IRS Publications 537 and 544.)

It appears the primary issue relates gain from the recapture of the deprecation you have claimed on the property and reporting it over the life of the installment contract versus all at once in the year of sale.
The first distinction to make with regards to the sale is whether the property falls under the rules of IRC Sec 1245 [most personal property] or IRC Sec 1250 [most real property].

The distinction is important because:

Sec 1245: The installment method of reporting does not apply to the portion of the sale resulting in ordinary income from the recapture of depreciation. That is, depreciation recapture is recognized in the year of sale regardless of the amount of payments received.
Sec 1250: The installment method of reporting does apply to the portion of the gain resulting from the recapture of depreciation, i.e., “unrecaptured Sec 1250 gain”. That is, depreciation recapture is recognized as payments are received.

The gain on the sale of Sec 1250 property can result in two different tax rates, which are applied in a specific order:

The first rate applies to the recapture of the depreciation…maximum rate of 25%.
The second rate applies to any remaining gain after taking into consideration the recapture of the depreciation…maximum rate of 20%, plus the Net Investment Tax of 3.8% which is depending on your income level.

There is a specific ordering of when gain is reported:

As payments are received, all of the income subject to the 25% rate [“first rate” or unrecaptured Sec 1250 gain] is recognized first.
Any remaining gain after the depreciation is recognized is subject to the 20% maximum rate [“second rate” or the long-term capital gain rate].

To summarize for clarification: while the unrecaptured Sec 1250 gain is recognized first, it is still only recognized as payments are received and not in the year of sale.”

Note: None of the information on this web page or website is tax or legal advice. Every tax situation is different. We have CPA resources that specialize in this area of the tax code available. Please contact us directly, and we will put you in touch.