Form 4797 and Section 1250 Depreciation Recapture on Real Estate

When you sell rental property or a business building, the depreciation deductions you took over the years come back to haunt you through Section 1250 recapture, a tax mechanism that forces you to pay a flat 25% rate on that accumulated depreciation. Form 4797 is where you separate out those gains, calculate the recapture tax, and report it to the IRS.

Why Section 1250 recapture exists and how it differs from Section 1245

Congress created Section 1250 recapture to claw back the tax benefits of depreciation deductions. Over a 27.5-year residential or 39-year non-residential holding period, you deduct the cost of a building from your taxable income—often $100,000+ per year. When you sell, the IRS wants some of that benefit back.

Section 1245 applies to personal property (equipment, machinery, vehicles) and recaptures all depreciation at ordinary income rates—up to 37% for high earners. Section 1250 applies only to real property (the building itself) and recaptures only at 25%, a gentler rate.

The distinction matters. If you own a manufacturing facility, the building is Section 1250 (25% recapture), but the specialized equipment inside is Section 1245 (ordinary income rates). Separating them on Form 4797 Part III requires carefully allocated basis between the real estate and the chattels.

How accumulated depreciation turns into recapture gain

Your accumulated depreciation is the total of all annual deductions you’ve claimed. If you bought a $500,000 rental building (land worth $100,000, building worth $400,000), you’d depreciate the $400,000 building portion at 1/27.5 per year, or roughly $14,545 annually. After 20 years, you’d have $291,000 in accumulated depreciation. If you then sell for $650,000, your realized gain is $150,000 ($650,000 sales price minus $500,000 adjusted basis). Of that $150,000, $291,000 would be Section 1250 recapture—but wait, you can’t recapture more than your total realized gain, so the entire $150,000 is Section 1250 recapture in this scenario.

Form 4797 Part III line 8 is where you enter accumulated depreciation. Line 9 tells you to compare depreciation to realized gain; whichever is smaller is your Section 1250 gain (the amount taxed at 25%). The excess gain, if any, is long-term capital gain and gets the preferential rates (0%, 15%, or 20% depending on income).

The distinction between recapture and long-term capital gain

A single sale often produces two types of gains taxed at different rates.

Suppose you sell a $500,000 building (straight-line depreciation, no land) for $750,000. Your adjusted basis is $500,000 (you’ve deducted depreciation over the years). Your realized gain is $250,000.

Of that $250,000, the first portion equals your accumulated depreciation. If you depreciated the building to zero (or nearly zero), all $250,000 is Section 1250 recapture. But if you bought the building used and have only $80,000 in accumulated depreciation, then $80,000 is recaptured at 25% and $170,000 is long-term capital gain at your applicable rate (likely 15% or 20% if you have substantial other income).

Form 4797 Part III separates these. Lines 8–17 walk through the recapture calculation; line 18 is your Section 1250 gain (taxed at 25%). Any remaining long-term gain flows to Schedule D.

This split is why depreciation is a valuable tool in real estate: you get full ordinary-deduction value on the way in (saving at your top marginal rate, potentially 37%), and you pay back at only 25% on the way out.

Filling in Form 4797 Part III correctly

Form 4797 Part III is for Section 1250 real property only. You must separately identify each property and its accumulated depreciation.

Start with the adjusted basis of the building (purchase price plus improvements, minus accumulated depreciation—this gives you the “book value” immediately before sale). Then enter sales price and calculate realized gain. Enter accumulated depreciation claimed. Compare depreciation to realized gain; the smaller number is your Section 1250 gain.

Common errors include:

• Including land depreciation (land isn’t depreciable).
• Mixing in Section 1245 property or personal property.
• Forgetting Section 179 expensing or cost-segregation adjustments that may have changed basis.
• Entering depreciation gross rather than net of any recapture in prior years.

If you’re selling multiple rental properties in one year, you’ll have multiple Part III entries, one per property. The gains add up and then flow together to Schedule D.

How Section 1250 recapture interacts with net investment income tax

Section 1250 recapture is treated as investment income for purposes of the 3.8% net investment income tax (NIIT) if your Modified Adjusted Gross Income exceeds thresholds ($200,000 single, $250,000 married). This means your 25% recapture gain could effectively be taxed at 28.8% (25% + 3.8%) in high-income scenarios.

Form 8960 calculates NIIT by adding investment income sources. Section 1250 gains from Form 4797 automatically flow into that calculation. Many sellers are surprised to owe NIIT on top of the headline recapture rate.

Installment sales and deferred recapture

If you sell the property on an installment sale (buyer makes payments over time), you recognize recapture gain proportionally as you receive payments. You don’t take the entire recapture hit in year one; it spreads over the payment period.

Form 6252 and Form 4797 interact here: Form 6252 calculates your recognized gain by year, and you then apply the Section 1250 percentage to that yearly gain on Form 4797 for each year you receive payments.

Like-kind exchanges and Section 1250 deferral

In a 1031 exchange, you defer realized gain, but not all of it avoids recapture. If you exchange a $500,000 building for a $500,000 different building (replacing the entire basis), your Section 1250 liability is deferred into the new property—when you eventually sell that new one, recapture applies to all the accumulated depreciation on both the old and new properties. The tax is deferred, not forgiven.

If you take boot in a 1031 exchange, Section 1250 recapture applies to the boot amount, even though you’re deferring the bulk of the gain. This is why 1031 exchanges are powerful: you can avoid net gain recognition while preserving the depreciation benefit, but the recapture obligation moves forward.

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