Apollo AdvisingDepreciation recapture: the tax most rental sellers forget
What depreciation recapture is, why it applies even if you never claimed depreciation, and how to estimate it before you sell a rental property.
Short answer. When you sell a rental for a gain, the depreciation you took, or were allowed to take, is generally taxed at a federal rate of up to 25% instead of the lower long-term capital gains rate. It applies even if you never claimed depreciation on your returns, which is why it surprises so many owners at closing.
How depreciation builds up
The IRS treats a residential rental building as wearing out over 27.5 years. Each year you deduct about 1/27.5 of what you paid for the building, not the land, against your rental income. That deduction lowers your taxable income while you own the property, and it also lowers your cost basis by the same amount.
When you sell, the gain is measured from that lower basis. The part of the gain that came from depreciation is called unrecaptured Section 1250 gain, and it is taxed at up to 25% at the federal level. The rest of the gain is taxed at the usual long-term capital gains rates.
The rule that catches people
Recapture is based on depreciation that was allowed or allowable. If you or a past preparer never claimed it, the IRS still reduces your basis as if you had. You pay the tax on a deduction you never received. If that describes your situation, ask a CPA about correcting it before you sell, since there is a formal process for catching up missed depreciation.
A worked example
Say you bought a rental for $300,000, with $60,000 of that allocated to land. The building portion is $240,000, so annual depreciation is about $8,727. After 10 years you have taken about $87,273.
| Line | Amount |
|---|---|
| Sale price | $450,000 |
| Selling costs at 7% | −$31,500 |
| Adjusted basis (price minus depreciation) | −$212,727 |
| Total gain | $205,773 |
| Portion from depreciation, taxed up to 25% | $87,273 |
| Remaining capital gain | $118,500 |
At the 25% maximum, the depreciation portion could cost up to $21,818 in federal tax. If the remaining gain is taxed at 15%, that adds $17,775. Higher earners may also owe the 3.8% net investment income tax on the full gain, about $7,819 here. Your actual rates depend on your income in the year of sale, so treat these as a rough ceiling and have your CPA run the real numbers.
Ways owners handle it
- Exchange instead of selling. A 1031 exchange defers both the capital gain and the recapture, as long as the rules are followed.
- Hold the property for life. Heirs generally receive a stepped-up basis, which wipes out the built-up depreciation. That is a planning question for your estate attorney and CPA.
- Pick the year of sale. Selling in a lower-income year, such as early retirement, can reduce the rate on the capital gain portion.
- Simply plan for it. Many owners still sell. They just want the after-tax number before they list, not after.
Where we fit
In a hold or sell session we estimate your basis, depreciation, and likely net proceeds so you can see the after-tax picture next to the cost of keeping the property, then bring a clean set of questions to your CPA. Apollo Advising does not prepare returns or give tax advice. More on deciding whether to hold, sell, or exchange.
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Free worksheet: hold, sell, or 1031?
The 12 questions Denver works through with every owner deciding whether to keep, sell, or exchange a rental, in a two-page PDF. Plain language, no sales pitch.
Go deeper
When a 1031 exchange does not make senseSix situations where paying the tax can beat deferring it, and how to run the comparison.The 1031 exchange timeline, step by stepThe 45-day and 180-day deadlines, the identification rules, and what to line up before you list.Renting out your old house instead of selling itThe three-year window for the home sale exclusion, what renting costs you in taxes, and how to decide.This page is general education, not legal, tax, investment, insurance, or lending advice. See our disclosures.