Depreciation recapture: the tax bill when you sell a rental

Depreciation recapture is the tax you pay when you sell a rental on the depreciation you deducted while you owned it. For the building itself, that portion of your gain is taxed at your ordinary income rate, capped at 25%, instead of the lower long-term capital gains rate.

It catches owners off guard because the deductions came in small pieces over many years and the bill arrives all at once.

What depreciation is

The IRS lets you deduct the cost of a rental building over its useful life, even while the property may be rising in value. For residential rental property, that period is 27.5 years. Land doesn't wear out, so you can't depreciate it. Each year's deduction lowers the rental's taxable income, and it also lowers your basis, which is the number your gain is measured from when you sell.

What recapture is, and the rate

When you sell, your gain is the sale price minus your adjusted basis. Because depreciation lowered your basis, part of that gain exists only because of the deductions you took. The tax code calls that part unrecaptured Section 1250 gain, and investors call it depreciation recapture. It's taxed at your ordinary income rate, but no higher than 25%. If you held the rental more than one year, any remaining gain, from actual appreciation, generally gets long-term capital gains rates of 0%, 15%, or 20% depending on your taxable income.

For the building itself, which must be depreciated straight-line, there's no additional ordinary-income recapture beyond this. Components depreciated faster, covered below, are different.

Higher earners may also owe the 3.8% net investment income tax on the gain. It applies when modified AGI is above $200,000 for single filers or $250,000 for married couples filing jointly. For how the rest of the gain is taxed, see capital gains on rental property.

"Allowed or allowable": skipping depreciation doesn't lower your gain

The tax code reduces your basis by the depreciation that was allowed or allowable. In plain terms, the IRS counts the depreciation you were entitled to take, whether or not you took it. IRS Publication 527 says to reduce your basis by "depreciation you deducted or could have deducted on your tax returns."

So an owner who skips depreciation to keep things simple doesn't come out ahead. They pay higher tax every year they own the property, then pay tax on a gain figured as if they'd taken it. If you've missed depreciation in past years, talk to your CPA now. The IRS provides ways to correct it, including an accounting method change in some cases.

A worked example

Here's an illustrative property. The numbers are simplified: a full year of straight-line depreciation each year, no selling costs, and no improvements.

That $115,273 gain splits in two:

• $55,273 of unrecaptured Section 1250 gain, equal to the depreciation (it's never more than your total gain). At the 25% maximum rate, that's up to $13,818 of tax.
• $60,000 of appreciation gain, the difference between the $290,000 sale and the $230,000 purchase. At a 15% capital gains rate, that's $9,000. At 20%, it's $12,000.

A higher earner could also owe the 3.8% net investment income tax on the full gain, and state tax may apply.

Recapture taxes the depreciation back at a rate capped at 25%. If those deductions offset income taxed above 25%, you came out ahead and kept the money in the meantime. If they sat unused as suspended passive losses, a fully taxable sale generally releases them, which can offset part of this bill.

Illustrative example. Actual results vary based on your purchase price, land allocation, holding period, sale price, selling costs, and tax bracket.

Talk to a 1031 consultant if you're planning a sale and want to see the timing.

How cost segregation changes the picture

A cost segregation study splits a property's cost into the building and shorter-lived parts, such as appliances, carpet, and land improvements. Those parts are depreciated over 5 or 15 years instead of 27.5, and they may qualify for bonus depreciation. The IRS's own audit guide notes that allocating costs to personal property gets "a faster depreciation write-off."

The trade comes at the sale. Some of those components, such as appliances, carpet, and furniture, are Section 1245 property. Gain on them is treated as ordinary income up to the depreciation you took, with no 25% cap. Land improvements, such as fences and paving, are usually Section 1250 property. Depreciation on them above the straight-line amount, including any bonus depreciation, is taxed as ordinary income, and the rest falls under the 25% maximum rate. So cost segregation moves deductions earlier and can move part of the recapture into a higher bracket later.

There's a second wrinkle for exchangers. Section 1031 only covers real property, and the tax code limits how far a like-kind exchange shelters Section 1245 recapture. Personal property components, such as appliances and furniture, aren't like-kind to real property, so recapture on them may be due even in an exchange. We compare the two approaches in cost segregation vs. straight-line. Have your CPA run both sets of numbers before you commission a study.

How owners defer or avoid recapture

A 1031 exchange. If you sell and buy like-kind real property through a qualified intermediary, you generally don't recognize the gain, including the part from depreciation. The deferred gain carries into the new property's basis. Cash, other non-like-kind property, or a smaller mortgage on the new property can make part of the gain taxable. Our 1031 exchange page and the guide to choosing a qualified intermediary cover the mechanics.

Holding until death. The basis of inherited property is generally its fair market value on the date of death. The recapture rules for Section 1245 and Section 1250 property also exclude transfers at death. In practice, the depreciation you took during your life is generally never taxed, and heirs start depreciating from the new, higher basis. Estate planning has its own rules, so this is a conversation for your CPA and estate attorney.

What doesn't work. Not claiming depreciation. As covered above, your gain is figured as if you had.

Your CPA confirms how recapture applies to your sale, and your qualified intermediary confirms how an exchange must be structured.

This article explains general federal tax rules for educational purposes. It is not tax advice. State taxes may also apply. Your CPA and qualified intermediary confirm how these rules apply to you.

Talk to a 1031 consultant or build my plan with my sale proceeds.