Depreciation Recapture on Rental Property

Depreciation recapture on rental property is not a single line that says “pay 25% and go home.” A taxable sale can split gain into unrecaptured section 1250 gain on the real property, section 1245 ordinary recapture on personal property (common after a cost-segregation study), and leftover capital gain. The mix depends on how you depreciated the building, not on how the listing agent titled the flyer.

IRS Tax Topic 409, Capital Gains and Losses is the official short version: gain on real property attributable to depreciation may be taxed at a maximum of 25% as unrecaptured section 1250 gain. Publication 544 and Publication 527 fill in the rental facts. Model this before you list, because a 1031, an installment sale, or a hold-to-death plan can change the bill more than another $10,000 of list price.

Depreciation Recapture on Rental Property: 1250 Versus 1245

Section 1250 (the building). Residential rental real property is generally depreciated straight line over 27.5 years (IRS Publication 527). Straight-line depreciation on real property does not create “additional” 1250 ordinary recapture the way old accelerated real-property methods did. It does create unrecaptured section 1250 gain: the depreciation you took (or were allowed) on the real property, taxed at a federal maximum of 25% to the extent of gain on that real property. Remaining gain on the realty can be long-term capital gain at the usual preferential rates, plus any net investment income tax that applies.

Section 1245 (personal property). Appliances, certain fixtures, and other personal property—especially amounts a cost segregation study moved into 5- or 7-year lives—are 1245 property. Gain on those assets is ordinary income to the extent of depreciation taken. That can be a higher rate than 25% for a high-bracket seller. Cost segregation that felt brilliant in year two can be expensive in year six if you sell taxable and a large slice of basis is 1245.

Land. Land is not depreciated. Gain on land is capital (subject to the usual holding-period rules). A sloppy purchase-price allocation that put too little into land and too much into 5-year property will show up at sale.

Keep a simple three-bucket worksheet: land, 1250 realty, 1245 personalty. Allocate the contract price (and selling costs) across those buckets the way your CPA will have to. If you cannot fill the worksheet, you are not ready to set a list price around “after-tax proceeds.”

Allowed or Allowable

You recapture depreciation that was allowed or allowable. If you owned a rental for eight years and never took depreciation, the IRS can still treat allowable depreciation as if you had. “I never claimed it, so I have no recapture” is a folk tale. File amended returns or ask a CPA how they will compute allowable if the history is messy—before you go under contract.

Bonus depreciation and section 179 (when it applied to the asset class) accelerate the same story: more taken sooner means more potential ordinary or 1250-character gain later.

1031, Installment, or Hold-to-Death

Like-kind exchange. A valid 1031 can defer gain, including much of the depreciation story, if you meet the rules and the replacement is real property for real property (IRS like-kind exchange tips). Deferral is not erasure. The replacement generally inherits a carryover basis story. Boot (cash or other non-like-kind property) can trigger gain now, and that gain often carries recapture character first. Plan boot as if it were a partial taxable sale.

Installment sale. Spreading principal can spread gain recognition, but recapture character has special ordering. Do not advertise “I’ll take payments so I avoid recapture.” Have the CPA model IRC section 453 against 1245/1250 before you accept a seller-finance offer.

Hold until death. A step-up in basis at death can wipe built-in gain and unused depreciation stories for heirs (estate-tax and community-property facts aside). That can make a taxable sale in the final illness a costly unforced error. It can also make a 1031 unnecessary if the real plan was always intergenerational hold. Coordinate with estate counsel; this is not a DIY timing trick.

Refinance instead of sell. A cash-out does not recapture. You keep the depreciation schedule and add debt. When to sell compares that branch to a listing.

How Financing Interacts (Without Changing the Tax Code)

DSCR and commercial underwriting do not “pay” your recapture. They can change which exit you can afford:

• A sale that must be free-and-clear for the buyer may force you to pay a prepay or defease and take the tax hit in the same quarter. Liquidity planning matters.
• A 1031 replacement that needs a DSCR or commercial loan has to close inside the 180-day clock. A failed refinance is how a deferred exchange becomes a taxable sale.
• Entity identity must match. Moving a building out of an S corp on the way to an exchange can be its own taxable event. See S corp vs LLC.

None of this is a reason to pick construction or a flip. Recapture math is for investment holds you already operate.

A Pre-List Tax File

1. Depreciation schedules (federal) for every year of ownership, including cost-seg reports.
2. Closing statement from the purchase (and any improvements).
3. Current loan payoff, prepay/defeasance estimate, and selling-cost estimate.
4. A CPA worksheet: 1245 ordinary, unrecaptured 1250, leftover LTCG, state tax, NIIT.
5. A parallel 1031 and cash-out column with the same selling costs assumed or not.

If the after-tax sale number is close to the cash-out number, the “I should list” instinct is often wrong.

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Frequently Asked Questions

Is depreciation recapture always 25%?

No. Unrecaptured section 1250 gain on real property has a federal maximum of 25% (Tax Topic 409). Section 1245 personal property recapture is ordinary income to the extent of depreciation and can be higher. Leftover gain on realty can be long-term capital gain at different rates. State tax is extra.

Does a 1031 eliminate recapture?

It can defer it if the exchange is valid and you do not take boot that forces recognition. The character generally carries into the replacement property. A later taxable sale still has a recapture story.

What if I never took depreciation on my rental?

Allowable depreciation can still enter the computation. Talk to a CPA before you assume a zero recapture number. Fixing unfiled depreciation is a tax-compliance project, not a listing-weekend project.

Does cost segregation make recapture worse?

It can increase the share of gain that is 1245 ordinary income, because more basis sat in short-life property. That is not automatically a reason to skip a study; it is a reason to model the exit at the same time as the year-one deduction.

Will a DSCR refinance trigger recapture?

A refinance is not a sale. You do not recapture by pulling cash, subject to the usual tax rules on how you use proceeds. You do take on a larger payment. If that payment breaks the property, you may be forced into the sale you were trying to avoid.