Depreciation Recapture When Selling a Business: §1245, §1250, and the Bonus Depreciation Trap

The biggest tax surprise in a business sale isn't the capital gains bill — it's the ordinary income tax on depreciation recapture. Every year you deducted depreciation, you reduced your basis and converted future sale proceeds into a higher-rate tax liability. At closing, the IRS collects that deferred bill first, at rates up to 37%, before any preferential capital gains rates apply.

What depreciation recapture is — and why it exists

When you buy a piece of equipment for $500,000 and depreciate it to zero, you've taken $500,000 of ordinary income deductions over the years — at rates up to 37%. When you later sell that equipment for $300,000, you've received $300,000 in cash for an asset with a zero tax basis. You made a $300,000 gain.

Without recapture, that $300,000 gain would be taxed as long-term capital gain at 20% (plus 3.8% NIIT). But that creates an asymmetry: you deducted the cost at 37% ordinary income rates, and you're recouping some of it as a 20% capital gain. Congress closed that gap with §§1245 and 1250. The IRS requires you to "recapture" as ordinary income any gain that is attributable to depreciation you previously deducted.

The mechanics: recapture applies to the lesser of (1) total depreciation taken or (2) the gain realized at sale. You can never be recaptured for more gain than you actually made.

§1245 recapture: equipment, vehicles, and certain intangibles

Section 1245 covers "§1245 property" — generally, personal property (not real estate) that was subject to depreciation or amortization. This includes:

• Machinery and equipment — manufacturing equipment, computers, servers, vehicles, restaurant equipment, medical equipment, construction equipment
• Furniture and fixtures
• §179 expensed property — if you immediately expensed an asset under §179, the full amount creates recapture potential at sale
• Bonus-depreciated property — 100% bonus depreciation produces the same result: 100% of the asset's cost becomes potential §1245 recapture at sale
• §197 amortizable intangibles — customer lists, trade names, covenants not to compete, licenses, and goodwill that was previously purchased and amortized over 15 years

How §1245 recapture is calculated

The formula: §1245 recapture = lesser of (total depreciation taken) OR (gain at sale)

Example: You bought a CNC machine for $400,000 and fully depreciated it to zero via bonus depreciation in Year 1. Five years later, you sell the business in an asset deal and allocate $250,000 to this machine.

• Total depreciation taken: $400,000
• Gain realized: $250,000 − $0 adjusted basis = $250,000
• §1245 recapture: lesser of $400,000 or $250,000 = $250,000 — all taxed at ordinary income rates

No portion of this $250,000 qualifies for the 20% capital gains rate. It is all ordinary income.

§1250 recapture: real estate

Real estate has a two-tier recapture structure — and the relevant tier for most business owners is the second one.

Tier 1: §1250 additional recapture (rare today)

The original §1250 rule taxes as ordinary income only the excess of accelerated depreciation over what straight-line depreciation would have been. For non-residential real property placed in service after 1986, MACRS requires straight-line depreciation — there is no excess to recapture. You'll only see §1250 additional recapture on very old real estate acquired before 1987 that used accelerated methods.

Tier 2: Unrecaptured §1250 gain (25% rate)

This is the tier that affects nearly every business owner who sells a building. Under §1(h)(1)(D), any gain on real property attributable to straight-line depreciation previously taken — even though MACRS depreciation is not "excess" over straight-line — is taxed at a maximum rate of 25%, not the standard 20% long-term rate.²

Example: You paid $1,500,000 for a building in 2014. By 2026, you've taken $480,000 in straight-line depreciation (39-year MACRS). Adjusted basis = $1,020,000. You sell the building for $1,800,000.

• Total gain: $1,800,000 − $1,020,000 = $780,000
• Unrecaptured §1250 gain (25% rate): the lesser of total depreciation taken ($480,000) or total gain ($780,000) = $480,000 taxed at 25%
• Remaining gain ($780,000 − $480,000 = $300,000): taxed at 20% LTCG + 3.8% NIIT = 23.8%

The OBBBA bonus depreciation trap: you may have accelerated a large future tax bill

The One Big Beautiful Bill Act (OBBBA, July 2025) permanently restored 100% bonus depreciation for qualified property acquired and placed in service after January 19, 2025.³ Previously, the TCJA had phased it down to 40% for 2025 and was eliminating it entirely. OBBBA reversed that and made 100% expensing permanent.

For capital investment decisions, this is unambiguously good. A $1M equipment purchase immediately produces a $1M deduction rather than a multi-year MACRS recovery. Cash-on-cash, the timing benefit is real.

But for business exit planning, there's a structural consequence: 100% bonus depreciation creates 100% §1245 recapture potential at sale.

This doesn't mean bonus depreciation is a mistake — the time value of the deduction up front often outweighs the recapture cost years later. But it does mean that business owners who have taken aggressive depreciation should factor the recapture exposure into their exit planning math. The deduction reduced your income tax bill in years past; recapture collects a portion of that benefit back at sale.

§179 expensing: the same issue

Section 179 immediate expensing works identically for recapture purposes. Property that was immediately expensed under §179 has an adjusted basis of zero. The gain at sale on that property — up to the amount expensed — is §1245 ordinary income. The OBBBA also permanently increased the §179 limit to $2.5M (indexed for inflation).³

§453(i): the installment sale trap — recapture cannot be deferred

Business sellers often assume that an installment sale (spreading the purchase price over multiple years) defers tax on all gain proportionally. For capital gains components, that's true. But §453(i) creates a hard exception for depreciation recapture that surprises many sellers.⁴

§453(i) rule: Depreciation recapture under §1245 and §1250 must be recognized as income in the year of sale — regardless of how much cash you actually receive that year. You cannot defer recapture income by using the installment method.

Example: You sell a $5M business in an asset deal. $1.2M of the gain is §1245 recapture. The buyer pays $500,000 down and $4.5M over five years.

• Year 1 cash received: $500,000
• Year 1 §1245 recapture income: $1,200,000 — recognized in full even though you only received $500,000
• Year 1 tax on recapture alone: $1,200,000 × 37% = $444,000

You received $500,000 but owe $444,000 in federal tax on the recapture component alone. That leaves $56,000 before state taxes. This creates a severe cash-flow problem that catches sellers off guard.

The remaining gain (the capital gains components) can still be deferred via the installment method. But the recapture portion must be paid in full at closing — meaning you need to plan for this liquidity requirement even if most of the proceeds are coming in over time.

Why a stock sale eliminates depreciation recapture

In a stock sale, the buyer purchases the shares of the company — not the underlying assets. The entity continues to own the equipment, real estate, and intangibles with the same tax basis as before. No asset is sold; no depreciation is recaptured.

For the seller, the entire gain on a stock sale is the difference between the share sale price and the stock basis. That gain is treated as long-term capital gain (assuming shares were held more than one year) at 20% + 3.8% NIIT = 23.8% federally.

This is why the asset sale vs. stock sale structure negotiation is so important for businesses with significant depreciable assets. Buyers typically want asset deals (they get a stepped-up basis in the purchased assets, creating future depreciation deductions). Sellers typically prefer stock deals (no recapture; all gain at capital rates). The value of the stock sale preference increases significantly with the amount of accumulated depreciation on the company's assets.

See our detailed guide: Asset Sale vs. Stock Sale: Complete Tax Guide.

Worked example: $10M asset sale in a manufacturing business

Let's model a $10M asset sale for a 15-year-old manufacturing company with significant equipment and owned real estate. The seller's marginal rate is 37% ordinary / 23.8% LTCG.

Effective federal tax rate on the $9M gain: ~26.9%

Now compare the same $10M sale as a stock deal, where the seller's stock basis is $1M:

• Gain: $10M − $1M stock basis = $9M, all long-term capital gain
• Federal tax: $9M × 23.8% = $2,142,000

The asset sale costs $276,000 more in federal tax — driven entirely by the §1245 recapture on equipment. With a larger proportion of depreciable assets or more recent bonus depreciation, the gap widens significantly.

Strategies to manage depreciation recapture exposure

1. Negotiate a stock sale structure

The cleanest solution. No asset changes hands; no recapture is triggered. Buyers will resist because they lose the stepped-up basis benefit — meaning they lose future depreciation deductions on the purchased assets. Sellers often need to offer a price concession or other terms to close the structure gap. For a business with $2M+ in accumulated depreciation, that concession is frequently worth it.

2. §338(h)(10) election for S-corps: understand the cost before agreeing

The §338(h)(10) election allows S-corp buyers and sellers to treat a stock sale as an asset sale for tax purposes. Buyers love this because they get the stepped-up basis. But sellers should be aware that agreeing to a §338(h)(10) election reinstates all the recapture exposure that a clean stock sale would avoid. The "structure premium" the buyer pays for a §338(h)(10) deal needs to exceed the recapture tax cost for the seller to come out ahead. Run the math before agreeing. See: §338(h)(10) Election Guide.

3. 1031 exchange for real estate held outside the operating entity

If the business's real estate is held in a separate entity (common in owner-operated businesses), the real estate can potentially be exchanged for like-kind replacement property under §1031, deferring the unrecaptured §1250 gain and any §1250 additional recapture. This only works if the real estate sale is separate from the business asset sale and meets §1031's identification and exchange timelines (45 days to identify, 180 days to close).⁵ See: Selling Business Real Estate: 1031, Sale-Leaseback, and §1250 Tax Guide.

4. Installment sale for the capital gains component (not recapture)

While §453(i) blocks installment deferral of recapture income, the remaining capital gains components — goodwill, appreciated real estate above the §1250 floor, franchise rights — can be deferred via installment sale. This reduces the present value of the capital gains tax even if recapture must be paid up front. The installment deferral benefit is smaller for businesses where recapture makes up a large share of the total gain.

5. Allocate more sale price to non-recapture assets in negotiation

Asset sale allocations are negotiated between buyer and seller, subject to arm's-length constraints and Form 8594 consistency. In the allocation negotiation, sellers should push for more price to be allocated to §1231/capital-gain assets (goodwill, going-concern value, customer relationships) and less to §1245 assets. Buyers generally prefer heavier allocation to short-lived §1245 property (faster depreciation recoup for them), so there's a natural conflict. A financial advisor or tax attorney should represent the seller's interests in this negotiation specifically.

6. Sell shares (QSBS) before significant asset depreciation

For C-corp owners who qualify for QSBS exclusion under §1202, the ideal structure is a stock sale — which preserves QSBS eligibility and eliminates recapture simultaneously. QSBS requires a stock sale by definition; agreeing to a §338(h)(10) or asset deal voids the §1202 exclusion. With the OBBBA's expanded $15M exclusion per taxpayer (and stacking strategies), QSBS-eligible sellers have strong structural reasons to hold out for a stock deal. See: QSBS Section 1202 Guide.

7. Cost segregation awareness — plan before sale, not after

Cost segregation studies reclassify building components from 39-year to 5-, 7-, or 15-year property, accelerating depreciation deductions. The flip side: reclassified components become §1245 property subject to recapture at ordinary income rates at sale, rather than §1250 property subject only to the 25% unrecaptured rate. If you're within 2–3 years of a sale and are considering a cost segregation study, model the recapture cost before proceeding — the recapture may cost more than the near-term deduction benefit.

Form 4797 and Form 8594: how recapture is reported

Form 4797: Sales of Business Property

All depreciation recapture flows through Form 4797, "Sales of Business Property." The form has three parts:⁶

• Part I — §1231 gains held more than one year (net §1231 gains get capital gain treatment if positive; losses get ordinary treatment)
• Part II — §1245 recapture and other ordinary gain/loss items, held any length of time
• Part III — §1231 calculations, §1250 recapture on real estate

The §1245 recapture computed on Form 4797 Part II flows to Schedule 1 of Form 1040 as ordinary income. The unrecaptured §1250 gain flows to the qualified dividends and capital gains worksheet and is taxed at the 25% rate.

Form 8594: Asset Acquisition Statement

When a business is sold as an asset deal, both buyer and seller must file Form 8594 reporting the agreed allocation of the purchase price among seven asset classes (Class I: cash; Class II: securities; Class III: receivables; Class IV: inventory; Class V: other tangible property; Class VI: §197 intangibles; Class VII: goodwill and going-concern value).⁷

Both parties must report the same allocation. Mismatched Form 8594s are an audit trigger. The allocation determines which assets receive recapture treatment and at what rates — which is why negotiating the allocation is as important as negotiating the headline purchase price.

A note on state income tax and recapture

Most states that have an income tax conform to the federal §1245 and §1250 recapture rules, meaning recapture is also taxed as ordinary income at state rates. California taxes recapture at 13.3% (no preferential capital gains rate); New York at up to 10.9%. High-tax-state business owners face federal + state recapture tax that can approach 50% of the recapture amount for income above the top bracket thresholds. This makes the stock-vs-asset-sale analysis even more important for California and New York business owners.

Related guides

• Asset Sale vs. Stock Sale: Complete Tax Guide
• Capital Gains Tax on Selling a Business: 2026 Rates and Real Math
• Installment Sale Strategy: IRC §453 Guide
• QSBS Section 1202: Qualification, Stacking, and OBBBA Changes
• Section 338(h)(10) Election: When the Structure Premium Isn't Worth It
• Selling Business Real Estate: 1031, Sale-Leaseback, and §1250 Tax Guide
• How to Reduce Taxes When Selling a Business: 7 Strategies

Sources

1. 26 U.S.C. § 1245 — Gain from dispositions of certain depreciable property (LII / Cornell Law). §1245(a)(1): recapture amount treated as ordinary income. 2026 top ordinary income rate 37% per IRC § 1(j)(2)(A) as amended by TCJA and extended. No inflation adjustment to the 37% bracket threshold structure for 2026.
2. 26 U.S.C. § 1250 — Gain from dispositions of certain depreciable realty (LII / Cornell Law); IRC § 1(h)(1)(D): unrecaptured §1250 gain taxed at maximum 25% rate. For post-1986 non-residential real property depreciated under straight-line MACRS, §1250 additional recapture is zero; all accumulated straight-line depreciation is "unrecaptured §1250 gain" at the 25% rate.
3. RSM US — "The OBBBA restores and expands bonus depreciation"; Moss Adams — "Tax Law Reinstates 100% Bonus Depreciation". OBBBA (One Big Beautiful Bill Act, July 2025) permanently restored 100% bonus depreciation under IRC § 168(k) for qualified property acquired and placed in service after January 19, 2025. §179 limit permanently increased to $2.5M (indexed). OBBBA also introduced IRC § 168(n) for 100% expensing of certain qualified production property. IRS issued interim guidance in Notice 2026-11.
4. 26 U.S.C. § 453(i) — Recapture Income (LII / Cornell Law). §453(i)(1): if a taxpayer uses the installment method, any recapture income under §§1245 or 1250 must be recognized in the year of disposition, not ratably as payments are received. The installment obligation's basis is increased by the recapture income recognized.
5. 26 U.S.C. § 1031 — Exchange of real property held for productive use or investment (LII / Cornell Law). §1031 permits deferral of gain (including unrecaptured §1250 gain) on qualifying like-kind real property exchanges. 45-day identification period; 180-day exchange period. Personal property no longer eligible after TCJA (2017).
6. IRS — About Form 4797, Sales of Business Property. Three-part structure for §1231 gains (Part I), ordinary recapture (Part II), and §1231 net calculations (Part III). §1245 recapture flows to Part II; §1250 unrecaptured gain flows to the Qualified Dividends and Capital Gain Tax Worksheet. Confirmed current for 2026 tax year.
7. IRS — About Form 8594, Asset Acquisition Statement Under Section 1060. Both buyer and seller must file Form 8594 in asset acquisitions reporting allocation of total consideration among seven asset classes. Allocations must be consistent between parties; IRC § 1060 residual method governs Class VII goodwill allocation.

Tax rates verified for 2026. Recapture rules under §§1245 and 1250 are complex and fact-specific; this guide is informational only. Consult a qualified tax advisor and fee-only financial advisor for analysis specific to your transaction.