Depreciation Recapture: What Happens When You Sell Rental Property
Depreciation is one of the main tax benefits of owning rental property. Each year, it reduces your taxable income without a matching cash expense. When you sell, however, the IRS generally takes back part of that benefit through depreciation recapture. For long-time owners, recapture can be a meaningful part of the tax bill, and it often surprises people who expected their entire gain to be taxed at long-term capital gains rates.
This guide explains how depreciation recapture works, how Section 1250 recapture applies to buildings, how cost segregation changes the picture, and the planning conversations worth having before you sell.
Start Here: A Complimentary Pre-Sale Wealth and Tax Review
If you are thinking about selling a rental or commercial property, an early look at the numbers can open up options. Compound offers a complimentary, no-obligation pre-sale wealth and tax review that may include:
Your adjusted basis: purchase price, improvements, and depreciation taken over the years
Estimated tax on a sale: capital gain, recapture, and state tax
Suspended losses: passive losses that may be released on a sale
Your plan for proceeds: reinvesting, diversifying, or funding retirement
What Is Depreciation Recapture?
When you depreciate a property, you lower its adjusted basis. When you sell, your gain is the sale price minus that lower basis. Depreciation recapture refers to the rules that tax the portion of the gain attributable to depreciation differently from the rest of the gain.
One detail catches many owners: basis is reduced by depreciation that was "allowed or allowable." In other words, if you were entitled to depreciation but never claimed it, your basis may still be reduced as if you had. Missed depreciation can sometimes be corrected before a sale, which is one reason to review your records early.
How Section 1250 Recapture Works for Buildings
Buildings and their structural components are generally Section 1250 property. For most rental buildings depreciated using the straight-line method, the portion of the gain equal to prior depreciation is often called "unrecaptured Section 1250 gain." It is generally taxed at a maximum federal rate that can be higher than the long-term capital gains rate that applies to the rest of the gain.
Put simply, when you sell a long-held rental at a profit, your gain may be split into layers:
Unrecaptured Section 1250 gain, up to the amount of depreciation taken on the building, taxed under its own rate cap.
Long-term capital gain on the appreciation above your original cost.
Ordinary income recapture on certain other property, discussed below.
Depending on your income, the net investment income tax and Wisconsin state income tax may also apply.
Cost Segregation and Section 1245 Recapture
A cost segregation study may reclassify parts of a building into shorter-lived property, such as certain fixtures, equipment, and land improvements. Much of that property is Section 1245 property. When it is sold, gain attributable to prior depreciation on Section 1245 property is generally recaptured as ordinary income, which may be taxed at higher rates.
That does not mean cost segregation is a poor choice. Accelerated deductions taken years earlier may be worth more than the added tax at sale, especially if they offset high-rate income. But the full trade-off belongs in a multi-year analysis. Our guides on cost segregation for large portfolios and whether cost segregation makes sense for small portfolios explore these questions.
Selling Rental Property Taxes: Planning Options to Discuss
Every sale is different, and each option has rules and trade-offs.
1031 exchange. Reinvesting proceeds in like-kind real property under specific timelines may defer both capital gains and recapture. The deferred gain carries into the replacement property.
Holding until death. Property held until death may receive a basis adjustment for heirs, which may eliminate built-in gain, including recapture, for income tax purposes. Coordinate with an estate attorney.
Installment sale. Spreading payments over several years may spread some of the gain, though recapture of ordinary income is generally taxed in the year of sale.
Releasing suspended losses. A fully taxable sale of a passive activity may release suspended losses, which can offset part of the tax.
Charitable planning. Gifts of property interests to charity or a charitable trust before a sale may be worth evaluating, with careful timing.
Timing the sale. Selling in a lower-income year, or pairing the sale with other losses, may affect the overall tax.
See our real estate capital event tax planning guide for more on structuring a large sale.
What Happens to the Money After the Sale?
A property sale often converts an illiquid, concentrated asset into cash. That is a wealth decision as much as a tax decision. Considerations include setting aside cash for taxes due, building a diversified portfolio, deciding whether to stay in real estate, and coordinating income needs in retirement. Read about building wealth beyond real estate.
To see how after-tax proceeds invested over time may grow under different assumptions, use the Compound calculator. Results are hypothetical and for illustration only.
Coordinated Planning for Wisconsin Property Owners
Compound combines wealth management with tax planning and preparation, so the sale and the reinvestment are planned together. We work with property owners throughout Wisconsin, including Milwaukee, Madison, Green Bay, Appleton, Kenosha, and La Crosse, as well as surrounding areas.
Planning a sale? Request a complimentary pre-sale wealth and tax review.
Frequently Asked Questions
What is depreciation recapture?
It is the tax treatment of the part of your gain that comes from depreciation you took, or were entitled to take, while owning the property. It is often taxed differently from the rest of the gain.
What is Section 1250 recapture?
Section 1250 covers buildings and structural components. For most straight-line depreciated rental buildings, gain equal to prior depreciation is "unrecaptured Section 1250 gain," taxed under a separate maximum rate.
Can I avoid depreciation recapture?
It may be deferred through a 1031 exchange and may be eliminated for heirs if property is held until death. Otherwise, it is generally owed when you sell.
What taxes apply when selling rental property?
Selling rental property taxes may include unrecaptured Section 1250 gain, ordinary income recapture on certain components, long-term capital gains, the net investment income tax, and state income tax.
Does cost segregation increase recapture?
It can, because some reclassified property is recaptured as ordinary income on sale. Whether the earlier deductions outweigh that cost depends on your situation.
Compound is a registered investment adviser. Registration does not imply a certain level of skill or training. This article is for informational and educational purposes only and should not be construed as personalized investment, tax, or legal advice. Tax laws are complex and subject to change. Strategies discussed may not be suitable for everyone, and there is no guarantee that any strategy will achieve its objectives or reduce taxes. Calculator results are hypothetical, are not guarantees of future results, and do not reflect any actual investment. Investing involves risk, including possible loss of principal. Diversification does not ensure a profit or protect against loss. Please consult your tax, legal, and financial professionals before acting on any information in this article. For more information, see Compound's Form ADV, available at adviserinfo.sec.gov.
About Compound Wealth
Compound Wealth is an integrated tax, wealth management, accounting, and business transition firm serving business owners, professionals, real estate investors, and families. Rather than viewing financial decisions independently, the firm takes a coordinated approach that considers how tax planning, wealth management, accounting, and long-term planning often intersect. This planning-first philosophy helps clients evaluate financial decisions within the context of their broader objectives.
