The 806 tax code is one of those IRS provisions that flies under most people’s radar, yet it can unlock real tax savings if you understand how it works. Whether you’re dealing with business property, depreciation schedules, or estate planning, IRC Section 806 touches several important areas of tax law. In this guide, we’ll break down what it means, how it applies to you, and the strategies savvy taxpayers use to make the most of it.
Table of Contents
What Is IRC Section 806?
Let’s start with the basics. The 806 tax code is part of the Internal Revenue Code and deals with depreciation recapture on certain types of property. Specifically, it addresses how the IRS treats gains when you sell depreciable real property that you’ve been deducting over time.
If you own rental properties, commercial real estate, or business buildings, you’ve likely taken depreciation deductions year after year. Those deductions reduce your taxable income, which feels great at tax time. But here’s the catch: when you eventually sell that property, the IRS wants to recapture some of those benefits. That’s where Section 806 comes in—it’s the rule that determines how much of your gain gets taxed at a higher rate.
Think of it this way: depreciation is a government incentive to encourage investment in real property. The IRS lets you deduct the cost gradually, but they’re not just going to let you skip taxes on that benefit forever. When you sell, they recapture the benefit through higher tax rates on the gain attributable to those depreciation deductions.
Depreciation Recapture Basics
Depreciation recapture is the mechanism the IRS uses to tax the gains from depreciation deductions you’ve claimed. Here’s how it works in practice:
You buy a commercial building for $500,000. Over 39 years, you deduct $10,000 per year in depreciation. After 10 years, you’ve deducted $100,000, reducing your adjusted basis from $500,000 to $400,000. Now you sell the building for $550,000. Your total gain is $150,000 ($550,000 sale price minus $400,000 adjusted basis).
Of that $150,000 gain, $100,000 is attributable to depreciation you claimed. Under the 806 tax code and related rules, that $100,000 portion gets taxed at a higher rate (typically 25% for Section 1250 property) instead of your normal capital gains rate (15% or 20%). The remaining $50,000 is taxed as a long-term capital gain.
This distinction matters. A lot. The difference between 25% and 15% on $100,000 is $10,000 in extra taxes. That’s why understanding depreciation recapture is crucial for anyone holding investment property.
Section 1250 Property Rules
The 806 tax code specifically applies to what the IRS calls “Section 1250 property”—which is real property (land and buildings) that’s depreciable. This includes:
- Rental apartment buildings
- Commercial office buildings
- Warehouses and industrial properties
- Shopping centers and retail spaces
- Hotels and hospitality properties
It does not include land itself (land isn’t depreciable) or personal property like machinery, vehicles, or equipment (those fall under Section 1245 and have different rules).
For Section 1250 property, the depreciation recapture tax rate is 25%. This is higher than the long-term capital gains rate but lower than ordinary income rates. It’s a middle ground—the IRS’s way of saying “we’re going to recover some of that tax benefit you got from depreciation, but not as harshly as if we taxed it as ordinary income.”
This is also why the distinction between Section 1245 and Section 1250 property matters. Personal property (Section 1245) gets recaptured at ordinary income rates, which could be 37% at the top bracket. Real property (Section 1250) caps out at 25%. If you have flexibility in how you structure your assets, this can be a meaningful planning opportunity.
How to Calculate Your Gains
Calculating the taxable gain under the 806 tax code requires careful record-keeping. Here’s the step-by-step process:
Step 1: Determine Your Adjusted Basis
Start with what you paid for the property (your original basis). Add any capital improvements you made. Subtract all depreciation deductions you’ve claimed. This gives you your adjusted basis at the time of sale.
Step 2: Calculate Your Total Gain
Subtract your adjusted basis from your sale price. This is your total realized gain.
Step 3: Identify Depreciation Recapture Amount
Look back at your tax returns and add up all the depreciation deductions you claimed on this property. This is your depreciation recapture amount (up to the amount of your total gain).
Step 4: Separate Your Gains
Your total gain splits into two parts: depreciation recapture (taxed at 25%) and any remaining gain (taxed as long-term capital gain at 15% or 20%).
Let’s use a real example. You bought a rental house for $300,000 in 2010. You claimed $150,000 in depreciation over 13 years. You sell it for $475,000.
- Adjusted basis: $300,000 – $150,000 = $150,000
- Total gain: $475,000 – $150,000 = $325,000
- Depreciation recapture: $150,000 (taxed at 25% = $37,500 in taxes)
- Section 1231 gain: $175,000 (taxed at 15% or 20% = $26,250 or $35,000 in taxes)
This is why many real estate investors work with CPAs or tax advisors before selling—the math gets complex quickly, and mistakes can be costly.
Real Estate & 806 Tax Code
Real estate investors feel the impact of the 806 tax code most acutely. If you’ve been holding rental properties for years, you’ve built up substantial depreciation deductions. When you eventually sell, that bill comes due.
This creates an interesting planning challenge. Many real estate investors hold properties longer specifically to defer the recapture tax. Others use strategies like estate planning to pass appreciated properties to heirs, who get a “step-up in basis” at death. This essentially wipes out the depreciation recapture tax obligation because the heir’s new basis is the fair market value at death, not the original purchase price.
Another strategy is using a 1031 exchange—a like-kind property exchange that allows you to defer both regular capital gains tax and depreciation recapture tax by rolling the proceeds into a similar property. This doesn’t eliminate the tax; it defers it indefinitely (or until you eventually sell without doing another exchange).
For real estate professionals, understanding the 806 tax code is essential to making informed decisions about when to hold, when to sell, and what structures might minimize your tax burden.
Business Property Considerations
If you operate a business and own the property where your business operates, the 806 tax code affects you too. Business owners often depreciate their buildings, leasehold improvements, and other real property fixtures.
Let’s say you own a small manufacturing facility that you’ve depreciated heavily. When you sell the business or the property, you’ll face depreciation recapture. This can be a surprise for business owners who haven’t been thinking about the long-term tax implications of their depreciation deductions.
One consideration: if you’re selling a business that includes real property, your accountant needs to allocate the purchase price between the building, the land, equipment, goodwill, and other intangible assets. This allocation affects how much of the gain is subject to the 806 tax code rules versus other tax rules. The IRS scrutinizes these allocations, so they need to be reasonable and well-documented.
Business owners also need to think about this when planning for succession or retirement. If you’ve built up a business over 30 years and depreciated the building significantly, the depreciation recapture tax could be a substantial liability when you exit.
Tax Planning Strategies
Now for the strategies that can actually save you money. Understanding the 806 tax code opens up several planning opportunities:
1031 Exchanges
If you’re selling real property, consider doing a 1031 exchange to defer both capital gains and depreciation recapture taxes. You have 45 days to identify replacement property and 180 days to close. It’s strict, but it works.
Installment Sales
Spread the gain over multiple years by offering seller financing or using an installment sale agreement. This can push depreciation recapture into future years when you might be in a lower tax bracket.
Charitable Donations
Donating appreciated property to charity can eliminate the depreciation recapture tax entirely while giving you a charitable deduction. This only works if the property qualifies and you meet IRS requirements.
Timing the Sale
If you’re close to retirement, consider whether selling before or after you retire changes your tax bracket or affects your Medicare premiums, net investment income tax, or other tax considerations. Sometimes deferring a sale by a year or two makes sense.
Passive Activity Loss Strategies
If you have passive activity losses from other rental properties, you might be able to use those to offset gains from a sale. This requires careful tracking and understanding of the passive activity rules.
Entity Structure
For business owners, the structure you use (sole proprietor, S-corp, C-corp, LLC, partnership) affects how depreciation recapture is taxed. This is complex, but there can be advantages to certain structures in certain situations.
Common Mistakes to Avoid
After years of working with clients on tax issues, I’ve seen these mistakes repeatedly:
Forgetting About Depreciation Recapture
The biggest mistake is simply not anticipating it. Sellers are often shocked when their accountant explains the 25% tax on depreciation recapture. Plan ahead.
Poor Record-Keeping
If you can’t document your depreciation deductions, you can’t properly calculate your gain. Keep copies of your tax returns and depreciation schedules for every year you owned the property.
Misclassifying Property
Confusing Section 1245 property (personal property, taxed at ordinary rates) with Section 1250 property (real property, taxed at 25%) can lead to incorrect tax calculations. Know what you own.
Ignoring State Taxes
The 806 tax code is federal. But many states have their own depreciation recapture rules and capital gains taxes. Don’t forget about state-level implications.
Waiting Too Late to Plan
If you’re already in escrow on a property sale, it’s too late to do a 1031 exchange or other planning strategies. Start thinking about this years before you sell.
DIY Tax Returns on Complex Sales
If you’re selling appreciated real property, hire a CPA or tax attorney. The cost of professional advice is tiny compared to the potential tax savings or mistakes you might avoid.
Frequently Asked Questions
What exactly is the 806 tax code?
The 806 tax code (IRC Section 806) is the IRS rule that requires depreciation recapture taxation when you sell Section 1250 property (depreciable real property). It ensures that the tax benefits you received from depreciation deductions are partially recaptured through higher tax rates on your gains.
Is depreciation recapture tax avoidable?
You can defer it (through 1031 exchanges or installment sales), eliminate it (through charitable donations), or pass it to heirs (through estate planning with step-up basis). But if you eventually sell the property for cash without using one of these strategies, the tax is due.
What’s the tax rate for depreciation recapture?
For Section 1250 property (real property), the rate is 25%. For Section 1245 property (personal property), it’s ordinary income rates, which can be as high as 37%.
Does the 806 tax code apply to my primary residence?
Not if you’ve lived in it as your primary residence. The Section 121 exclusion lets you exclude up to $250,000 (or $500,000 if married) of gain from your primary residence. However, any depreciation deductions you claimed (if you used part of it for business or rental) would still be subject to recapture.
How do I report depreciation recapture on my tax return?
You report it on Form 4797 (Sales of Business Property) and Schedule D (Capital Gains and Losses). Your tax software or CPA will handle this, but understanding the concept helps you follow along.
Can I reduce depreciation recapture tax by not claiming depreciation?
Technically, yes—but it’s not a good strategy. Even if you don’t claim depreciation, the IRS can require you to recapture it anyway if you later sell. You’re better off claiming the deductions and dealing with the recapture tax when you sell.
What’s the difference between the 806 tax code and Section 1231 gains?
Section 1231 is a broader rule about business property gains. Depreciation recapture (the 806 tax code) is a subset of Section 1231. When you sell business property, part of your gain might be depreciation recapture (25% tax) and part might be regular Section 1231 gain (15-20% capital gains tax).
Do I need to file anything special to do a 1031 exchange?
You file Form 8824 with your tax return. But the real complexity is in the timing and identifying replacement property. You must identify replacement property within 45 days and close within 180 days. Many investors use qualified intermediaries to handle the mechanics.
Conclusion
The 806 tax code isn’t flashy or exciting, but it’s important. If you own real property that you’ve been depreciating, understanding how depreciation recapture works is essential to smart tax planning. The difference between paying 25% tax on a gain versus 15% could mean tens of thousands of dollars.
Here’s what you need to do: First, understand whether you own Section 1250 property (real property) or Section 1245 property (personal property). Second, keep meticulous records of your depreciation deductions. Third, start thinking about your exit strategy years before you plan to sell. Fourth, work with a qualified tax professional when you’re ready to sell.
The IRS designed the 806 tax code to recapture the tax benefits of depreciation. But that doesn’t mean you can’t be strategic about it. Smart investors use 1031 exchanges, installment sales, charitable donations, and other strategies to minimize or defer the impact. You can too—but only if you understand the rules and plan ahead.
If you’re managing rental properties, commercial real estate, or business property, add “understand depreciation recapture” to your financial checklist. Your future self will thank you when you’re ready to sell.
For more on related tax topics, check out our guides on Schedule 1 tax forms, 5498 tax forms, whether legal fees are tax deductible, and LLC tax loopholes. And if you’re planning an estate, our estate tax calculator can help you think through the implications.
