Section 1255 Property: Recapture, Exceptions, and Form 4797

Section 1255 property is land or an improvement that was paid for, in whole or in part, by a government conservation cost-sharing payment that the owner excluded from gross income under Section 126 of the Internal Revenue Code. The label matters because it carries a recapture rule: if you sell or otherwise dispose of that property within 20 years of receiving the excluded payment, part or all of your gain is taxed as ordinary income instead of at capital gain rates. The recapture percentage starts at 100% for the first 10 years and phases down to zero at year 20.

What Makes Property Section 1255 Property

The classification has nothing to do with the type of land, its use, or where it sits. It depends entirely on where the money for the improvement came from. If you acquired, improved, or modified property using cost-sharing payments from a qualifying federal, state, or local conservation program, and you excluded those payments from gross income under Section 126, the property is Section 1255 property.¹

The improvements are the kinds of projects you would expect a conservation program to fund: drainage systems, terraces, water storage structures, erosion barriers, forest health treatments, and wildlife habitat work. Both the underlying land and the installed improvement can carry the Section 1255 tag. Whatever parcel received the benefit of the excluded payment picks up the recapture potential.

One consequence catches taxpayers off guard. Because you never paid tax on the cost-sharing money, your adjusted basis in the property does not go up by the amount excluded. Lower basis means larger gain on sale, and that larger gain is what the recapture rule operates on.

Conservation Programs That Qualify Under Section 126

Not every government payment to a landowner sets up Section 1255 property. Only payments from programs listed in Section 126(a), or programs the Secretary of the Treasury has determined to be substantially similar, qualify for the exclusion in the first place.² Those categories include the rural clean water program under the Federal Water Pollution Control Act, the water bank program, the agricultural conservation program under the Soil Conservation and Domestic Allotment Act, the rural abandoned mine program under the Surface Mining Control and Reclamation Act, emergency conservation measures under the Agricultural Credit Act of 1978, resource conservation and development programs, small watershed programs, and state or local programs primarily aimed at conserving soil, protecting the environment, improving forests, or providing wildlife habitat. The IRS has recognized programs like the Forest Health Protection Program under the “substantially similar” category.³

A common question involves the Environmental Quality Incentives Program (EQIP), one of the largest current conservation payment programs. The IRS has stated that at least some EQIP components have not received the required determination from the Secretary of Agriculture that they are primarily for conservation purposes, and the Secretary of the Treasury has not classified them as substantially similar to the listed programs.⁴ Verify a specific EQIP subprogram’s status before claiming the exclusion.

Even for qualifying programs, only part of the payment may be excludable. A payment “substantially increases” annual income, and is therefore not excludable beyond a formula ceiling, when it exceeds the greater of 10% of the average annual gross receipts from the affected acreage over the prior three tax years, or $2.50 multiplied by the number of affected acres.⁵ The Secretary of Agriculture must also certify the payment as primarily for conservation, and the payment cannot be tied to an expense you deducted elsewhere. The total amount you excluded across all payments for a given property sets the maximum that can ever be recaptured on that property.

The 20-Year Recapture Rule

Section 1255 recapture converts capital gain into ordinary income when you dispose of the property before enough time has passed to justify keeping the exclusion. The recapture amount is the lesser of two figures: the applicable percentage of the excluded payments attributed to the property, or the gain realized on the disposition (reduced by any amount already recaptured under other provisions such as Section 1245 or 1252).⁶ The realized gain is a hard ceiling. You never owe recapture on more gain than you actually have.

The applicable percentage phases down over 20 years, counted from the date of the last excluded payment. Within the first 10 years, it is 100%. After that, it drops by 10 points for each year or part of a year the property is held beyond 10 years.⁷ The “part of a year” language matters. A sale at 10 years and three months already counts as one period past 10 years, dropping the percentage to 90%.¹

0 through 10 years: 100%
Over 10, up to 11 years: 90%
Over 11, up to 12 years: 80%
Over 12, up to 13 years: 70%
Over 13, up to 14 years: 60%
Over 14, up to 15 years: 50%
Over 15, up to 16 years: 40%
Over 16, up to 17 years: 30%
Over 17, up to 18 years: 20%
Over 18, up to 19 years: 10%
20 years or more: 0%, no recapture

A Worked Example

A taxpayer received $50,000 in excluded cost-sharing payments in March 2010 and sells the property in June 2023. The holding period is 13 years and 3 months. The excess over 10 years is 3 years plus a partial year, which counts as 4 periods under the “year or part thereof” rule. The applicable percentage is 100% minus 40%, or 60%. Potential recapture is $50,000 × 60% = $30,000.

If the realized gain on the sale is $40,000, recapture is the lesser of $30,000 or $40,000, so $30,000 is ordinary income and the remaining $10,000 is capital gain. If the realized gain were only $20,000, recapture would be capped at $20,000. If the sale produced a loss, no recapture would apply.

What Triggers Recapture, and What Doesn’t

Any taxable disposition of Section 1255 property within 20 years can trigger recapture. Sales for cash, exchanges, installment sales, involuntary conversions through condemnation or casualty, corporate distributions to shareholders, and certain contributions to partnerships or corporations all fall inside the rule.¹ Section 1255 overrides most nonrecognition provisions in the tax code, including those governing corporate liquidations, contributions to controlled corporations, partnership contributions, and like-kind exchanges.⁸

Two boundaries matter. Recapture never applies to a loss. If the sale price is less than adjusted basis, there is no gain to convert. And where the disposition is not a sale, if fair market value is less than or equal to adjusted basis, recapture also does not apply.¹

Transfers That Defer or Eliminate Recapture

Transfer at Death

Death is the cleanest exit. When Section 1255 property passes to an heir, no recapture is triggered. The heir receives a stepped-up basis to fair market value and the recapture liability is permanently extinguished.⁹ For older landowners inside the 20-year window, this simplifies the hold-versus-sell decision considerably.

Gifts

Gifts defer recapture rather than eliminate it. The donor recognizes no recapture income at the time of the gift, but the recipient inherits the recapture potential along with the property. The 20-year clock keeps running from the original payment date, not from the date of the gift, so the recipient needs the donor’s records.⁹ A part-sale, part-gift transfer triggers recapture on the sale portion and defers the rest.

Like-Kind Exchanges and Involuntary Conversions

Section 1031 exchanges and Section 1033 involuntary conversions limit recapture but do not necessarily eliminate it. Recapture applies only to the extent of gain that would be recognized without regard to Section 1255. A clean like-kind exchange with no boot means zero recognized gain and zero recapture. Any boot pulls recapture in up to the applicable percentage of excluded payments. The remaining recapture potential attaches to the replacement property.⁹ The same limit-and-carryover approach applies to contributions to controlled corporations and to partnerships.

Reporting on Form 4797

Section 1255 recapture is reported in Part III of Form 4797, Sales of Business Property.⁷ Line 20 takes the amount realized on a sale, exchange, or involuntary conversion, or fair market value for any other disposition. Line 23 takes the adjusted basis. Line 29a is the applicable percentage from the holding-period phase-out. Line 29b is the lesser of the gain on line 24 (reduced by ordinary income from other recapture provisions) or the amount from line 29a. That is your Section 1255 ordinary income.

The recaptured amount flows from Part III to Part II as ordinary income. Any remaining gain typically becomes Section 1231 gain, which receives capital gain treatment if Section 1231 gains exceed losses for the year.¹⁰ Underreporting recapture exposes you to the standard IRS penalties for underreported tax, and where the understatement is substantial, a 20% accuracy-related penalty on top of the tax and interest.

The Election to Include Payments in Income

Section 126(c) lets you elect not to exclude the cost-sharing payment in the first place. If you make the election, you pay income tax on the payment in the year received, your basis increases by the payment amount, and Section 1255 never applies to that property.¹¹ To claim the exclusion instead, you attach a statement to your return for the year you received the last payment for the improvement, showing the dollar amount funded by the government, the value of the improvement, and the amount excluded. Skip that step and the payments are simply taxable income, with no Section 1255 consequences later.

The election is worth considering when you expect to sell within the 20-year window. Paying tax on the payment now at a known rate can be cheaper than ordinary-income recapture years later on a larger gain, especially if your income is rising. For property you plan to hold for decades or pass at death, the exclusion is usually the better outcome.

Partial Dispositions

Selling only part of a parcel that received excluded payments requires allocating those payments between the portion sold and the portion retained. The statute does not prescribe a specific method but points to rules similar to those used for Section 1245 property.⁶ In practice, allocation follows relative fair market values or acreage, depending on the nature of the improvement. If the improvement benefits the whole parcel evenly, acreage works. If it benefits only a specific area, the excluded payments should be assigned to that area. Document the reasoning either way. An allocation that conveniently minimizes recapture on the sold portion invites scrutiny, and the IRS expects the split to reflect economic reality.

1
eCFR. 26 CFR 16A.1255-1 – General Rule for Treatment of Gain From Disposition of Section 126 Property
2
Office of the Law Revision Counsel. 26 USC 126 – Certain Cost-Sharing Payments
3
Internal Revenue Service. Revenue Ruling 2009-23
4
Internal Revenue Service. CONEX-147549-11 – Section 126 EQIP Determination
5
Internal Revenue Service. CONEX-147549-11 – Section 126 Excludable Portion
6
Office of the Law Revision Counsel. 26 USC 1255 – Gain From Disposition of Section 126 Property
7
Internal Revenue Service. Instructions for Form 4797 (2025)
8
eCFR. 26 CFR Part 16A – Temporary Income Tax Regulations
9
eCFR. 26 CFR Part 16A – Temporary Income Tax Regulations – Section 16A.1255-2
10
Internal Revenue Service. Instructions for Form 4797
11
eCFR. 26 CFR 16A.126-2 – Section 126 Elections