Depreciation Recapture on Rental Property

When you sell a rental property, the IRS doesn’t just tax your profit. It also wants back a portion of the tax breaks you claimed while you owned the property. That’s depreciation recapture, and for many investors, it’s the tax bill they didn’t see coming.

This article explains how depreciation recapture works, how it’s calculated, how it interacts with capital gains tax, and what investors can do to reduce the hit.

What Is Depreciation Recapture?

Types of Depreciation Recapture in Real Estate

Section 1250 Recapture: Real Property

Section 1250 applies to buildings and structural components depreciated using the straight-line method, which is standard for residential and commercial rental property.

• Unrecaptured Section 1250 gain is taxed at a maximum rate of 25%, even if your regular long-term capital gains rate is lower.
• Section 1250 recapture (true recapture) applies when accelerated depreciation was used, typically on land improvements. This portion is taxed as ordinary income, up to 37%.

Most residential rental property falls into the unrecaptured Section 1250 category.

Section 1245 Recapture: Personal Property

Section 1245 covers personal property inside the rental: appliances, equipment, furniture, flooring, and similar assets. Any depreciation taken on these items is recaptured as ordinary income when you sell.

Example: You depreciated $10,000 worth of appliances over several years. When you sell the property, the IRS recaptures that $10,000 as ordinary income, taxed at your marginal rate up to 37%.

Quick Comparison: Section 1245 vs. Section 1250

How Is Depreciation Recapture Calculated?

The calculation starts with your adjusted basis, which is what you originally paid for the property minus the total depreciation you claimed.

Formula:

• Adjusted basis = Purchase price minus total depreciation claimed
• Total gain = Sale price minus adjusted basis
• Recaptured gain = The portion of that gain equal to depreciation taken (taxed at up to 25% for Section 1250, ordinary income for Section 1245)
• Remaining gain = Taxed at long-term capital gains rates (0%, 15%, or 20%)

Depreciation Recapture Example Calculation

Here’s how it breaks down on a typical rental property sale:

• Purchase price: $400,000
• Depreciation claimed over 10 years: $100,000
• Sale price: $550,000

Step 1: Adjusted basis
$400,000 minus $100,000 = $300,000

Step 2: Total gain
$550,000 minus $300,000 = $250,000

Step 3: Tax breakdown

• $100,000 unrecaptured Section 1250 gain, taxed at up to 25% = up to $25,000
• $150,000 remaining gain, taxed at long-term capital gains rate (15% or 20%) = $22,500 to $30,000

Total estimated tax: $47,500 to $55,000
Without accounting for depreciation recapture, many investors only plan for the capital gains portion and end up surprised at closing.

How Depreciation Recapture Interacts with Capital Gains Tax

Depreciation recapture and capital gains tax on real estate are separate calculations that stack on top of each other in the same sale.

Here’s how they layer:

1. First, the IRS identifies how much of your gain is attributable to depreciation. That portion is taxed at the recapture rate: up to 25% for Section 1250, ordinary income for Section 1245.
2. Any gain above the depreciation amount is taxed at long-term capital gains rates of 0%, 15%, or 20% depending on your income.
3. If you’re a high-income earner, the 3.8% Net Investment Income Tax (NIIT) may also apply on top of both.

The result is that the effective tax rate on a rental property sale is often higher than investors expect, particularly for properties held a long time with significant depreciation accumulated.

Strategies to Reduce or Defer Depreciation Recapture Tax

1. Offset Gains with Passive Losses

If you have suspended passive losses from prior years, losses from rental properties you couldn’t deduct due to income limits, those losses can offset your recaptured gain when you sell. This is sometimes called the lazy 1031 exchange, and it can reduce your overall tax bill without any complex structuring.

Track your suspended passive losses on Form 8582. They’re easy to overlook and valuable at the time of sale.

2. Use a 1031 Exchange

A 1031 like-kind exchange lets you defer both capital gains tax and depreciation recapture by rolling your proceeds into another investment property. As long as you follow the rules, identifying a replacement property within 45 days and closing within 180 days, the tax is pushed forward and potentially deferred indefinitely.

One important note: 1031 exchanges only work for investment or business property. Primary residences and fix-and-flips don’t qualify.

3. Step-Up in Basis at Death

When property passes to heirs, the cost basis resets to the fair market value at the date of death. All accumulated depreciation and the recapture tax that would have come with it disappears entirely. Heirs can sell the property without owing any depreciation recapture tax on deductions taken during the prior owner’s lifetime.

It’s worth factoring in if you’re deciding whether to sell now or hold long-term. Read more about the Step-Up in Basis.

4. Time the Sale to a Lower-Income Year

Depreciation recapture rates, especially for Section 1245 assets taxed as ordinary income, are directly tied to your marginal tax bracket. Selling in a year when your income is lower can reduce the rate on that portion of the gain. This works well in retirement or during a year with large deductible expenses.

5. Cost Segregation

Cost segregation accelerates depreciation by reclassifying building components as shorter-life assets. It generates larger deductions upfront but also increases your future recapture exposure. It’s useful for cash flow, but understand the long-term tax trade-off before going in.

FAQs on Depreciation Recapture

What is unrecaptured Section 1250 gain? It’s the portion of your gain on a real property sale that’s equal to the straight-line depreciation you claimed. It’s taxed at a maximum rate of 25%, which is higher than the standard long-term capital gains rate for many investors.

Can losses offset depreciation recapture tax? Yes. Suspended passive losses can offset recaptured gain, including the Section 1250 portion. This is one of the most practical ways to reduce recapture tax without restructuring the sale.

Can you avoid depreciation recapture by not claiming depreciation? No. The IRS calculates recapture based on depreciation you were allowed to take, whether you actually claimed it or not. Skipping depreciation deductions doesn’t reduce your recapture exposure.

Does depreciation recapture apply to primary residences? Generally no. But if you previously rented out your home, any depreciation claimed during the rental period is subject to recapture when you sell, even if the rest of the gain qualifies for the primary residence exclusion.

Is depreciation recapture taxed at the same rate as capital gains? Not exactly. Unrecaptured Section 1250 gain is taxed at up to 25%. Section 1245 recapture and true Section 1250 recapture are taxed as ordinary income up to 37%. Standard long-term capital gains rates of 0%, 15%, or 20% apply only to the gain above the depreciated amount.

Wrapping Up

Depreciation recapture catches a lot of investors off guard because the tax savings during ownership can obscure the bill that’s coming at sale. Understanding which type of recapture applies, how the calculation works, and what strategies are available can make a real difference in your net proceeds.

A 1031 exchange, passive loss offsets, and proper sale timing are the main tools. A real estate CPA can help you figure out which combination makes sense before you list.