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When you sell residential rental real estate at a gain, the portion of long-term gain attributable to depreciation is generally treated as unrecaptured Section 1250 gain and can be taxed at a maximum federal rate of 25%.
The remaining long-term capital gain generally falls under the applicable long-term capital gains rate. Some investors may also owe the 3.8% Net Investment Income Tax.
Your actual tax depends on your adjusted basis, depreciation allowed or allowable, selling expenses, total gain, income, filing status, prior exchanges and whether separately depreciated assets are included in the sale.
Selling a rental property can produce a larger tax bill than investors expect.
The calculation is not simply sale price minus purchase price. Years of depreciation reduce the property’s adjusted tax basis. Once the property is sold at a gain, that lower basis affects how much gain is taxable and how part of that gain is treated for federal income tax purposes.
For most residential rental property held for more than one year, the depreciation-related part of the gain is generally treated as unrecaptured Section 1250 gain, which can be taxed at a maximum federal rate of 25%.
That is different from saying every dollar of depreciation is automatically taxed at 25%.
For investors, the real question is not just how much the property has appreciated, but how depreciation has changed the taxable gain and what that means for the next move.
Table of Contents
What Is Depreciation Recapture on a Rental Property?
Rental property depreciation allows an investor to recover the depreciable cost of an income-producing property over time.
Under IRS Publication 527, residential rental buildings placed under the general depreciation system are generally depreciated over 27.5 years. Land is not depreciable.
Each depreciation deduction also reduces the property’s adjusted basis, which becomes important at sale.
A property may have appreciated in market value at the same time its tax basis has fallen because of years of depreciation. The taxable gain can therefore be considerably different from the investor’s simple purchase-price-to-sale-price appreciation.
There is also a technical distinction that is frequently lost in articles about “depreciation recapture.”
For residential rental real estate held for more than one year and depreciated using the straight-line method, the depreciation-related gain generally does not become ordinary income under the traditional Section 1250 recapture rule. Instead, it is generally classified as unrecaptured Section 1250 gain and can be taxed at a maximum 25% federal rate.
IRS Publication 544 explains the distinction between Section 1250 depreciation recapture and unrecaptured Section 1250 gain.
What Is the Depreciation Recapture Tax Rate on Rental Property?
The often-repeated answer is 25%, but that needs context.
The IRS describes 25% as the maximum tax rate on unrecaptured Section 1250 gain. It should not be treated as an automatic 25% tax on every depreciation deduction an investor has taken.
| Portion of Gain | General Federal Tax Treatment |
|---|---|
| Unrecaptured Section 1250 gain | Maximum federal rate of 25% |
| Remaining long-term capital gain | Generally subject to the applicable long-term capital gains rate |
| Net investment income, when applicable | Potential additional 3.8% Net Investment Income Tax |
| Certain Section 1245 assets | Depreciation recapture may be treated as ordinary income under Section 1245 rules |
The Net Investment Income Tax is 3.8% of the lesser of net investment income or the excess of modified adjusted gross income over the applicable statutory threshold.
The thresholds are $250,000 for married couples filing jointly, $125,000 for married filing separately, and $200,000 for single or head-of-household filers.
State taxes are separate and depend on where the taxpayer and property are located.
How Do You Calculate Depreciation Recapture on a Rental Property?
Start with the property’s tax basis, not its equity.
IRS Publication 551 explains that basis changes over time. Qualifying capital improvements can increase it. Depreciation reduces it.
A simplified sale calculation looks like this:
The last calculation is deliberately expressed as a framework rather than a one-line tax formula. The IRS calculation can require additional adjustments, particularly if the property has prior exchanges, installment-sale treatment, separately depreciated assets or other tax history.
That is also why equity is not the same as taxable gain.
Your mortgage balance may affect how much cash you receive at closing, but it does not replace the tax-basis calculation used to determine gain.
What Does “Allowed or Allowable” Depreciation Mean?
One of the easiest mistakes to make is assuming that depreciation only creates a future tax consequence if you actually claimed the deduction.
The IRS generally uses allowed or allowable depreciation when adjusting basis.
Publication 551 states that basis must be decreased by depreciation you deducted or could have deducted under the depreciation method used. If no depreciation deduction was taken, basis can still have to be reduced by the amount that could have been deducted.
So deliberately skipping depreciation is generally not a strategy for avoiding its effect on basis when the property is eventually sold.
If an investor discovers that depreciation was missed or calculated incorrectly in prior years, the tax treatment should be reviewed with a CPA or other qualified tax professional before the sale.
How Does Cost Segregation Affect Depreciation Recapture?
A cost segregation study can accelerate depreciation by separating eligible components of a building into shorter recovery periods.
That can create larger deductions earlier in the investment and make the exit calculation more complicated.
A residential building itself is generally Section 1250 property. Some property separated through cost segregation may instead fall under Section 1245.
Under IRS Publication 544, gain on depreciable Section 1245 property can be recaptured as ordinary income to the extent required under Section 1245 rules.
An investor who used cost segregation therefore should not assume that every dollar of accumulated depreciation will receive the same maximum 25% treatment associated with unrecaptured Section 1250 gain.
This is especially relevant for investors who have also used bonus depreciation on qualifying shorter-life property.
The front-end deduction and the eventual disposition belong in the same analysis.
Can a 1031 Exchange Defer Depreciation Recapture?
A qualifying Section 1031 exchange can defer eligible gain when investment or business real estate is exchanged for qualifying like-kind real property. It does not generally wipe the deferred gain away.
Under the IRS rules for like-kind exchanges, the nonrecognition rules now apply to qualifying exchanges of real property.
For a deferred exchange, the investor generally has 45 days to identify replacement property and must receive it within 180 days or the applicable tax-return deadline, whichever comes first.
Ziffy’s 1031 exchange rules guide covers the structure and timelines in more detail. Investors can also use our 1031 exchange calculator when comparing a taxable sale with an exchange.
If the replacement property must be acquired before the existing investment property is sold, a reverse 1031 exchange uses a different transaction sequence.
Cost-segregated assets require extra care because Section 1031 applies to real property. An exchange involving a property with substantial shorter-life assets should be reviewed asset by asset rather than assuming the entire depreciation history automatically carries identical treatment.
Does Converting a Rental Into a Primary Residence Eliminate Depreciation Recapture?
No. An investor may eventually qualify to exclude some home-sale gain under Section 121 if the applicable ownership and use requirements are met, but that does not erase depreciation from the rental period.
The IRS specifically states that gain attributable to depreciation allowed or allowable for rental or business use after May 6, 1997 cannot be excluded under the home-sale exclusion.
See the IRS guidance on selling a home previously used as rental property. The sale therefore needs both the home-sale exclusion analysis and the depreciation analysis.
Should You Sell, 1031 Exchange, or Refinance a Rental Property?
Taxes are only one part of the decision. An investor considering a sale should first determine the after-tax proceeds, then compare that amount with what could be accomplished by continuing to own the property.
That comparison might include:
- selling and redeploying the remaining capital;
- completing a qualifying 1031 exchange;
- keeping the rental and continuing to collect income;
- refinancing to change the existing debt structure; or
- using a cash-out refinance to access part of the property’s equity without selling it.
If the objective is primarily to release capital rather than dispose of the property, refinancing deserves a separate calculation.
A DSCR loan can be used for eligible investment-property refinances and cash-out refinances. Because DSCR financing looks primarily at rental income rather than personal income, it can also fit investors whose tax returns contain substantial real estate deductions.
Ziffy can help investors analyze rental economics and financing options. Tax consequences should be calculated by the investor’s CPA, enrolled agent or tax attorney.
What Records Do You Need Before Selling a Depreciated Rental Property?
A good sale estimate starts with the depreciation schedule and tax basis records.
| Record | Why You Need It |
|---|---|
| Original closing statement | Helps establish acquisition cost and capitalized closing costs. |
| Land and building allocation | Separates nondepreciable land from the depreciable building basis. |
| Depreciation schedule | Shows accumulated depreciation and any separately depreciated assets. |
| Capital improvement records | Qualifying capital improvements can increase the property’s adjusted basis. |
| Cost segregation report | Identifies shorter-life assets that may receive different recapture treatment. |
| Estimated selling costs | Eligible disposition expenses affect the amount realized from the sale. |
| Prior 1031 exchange records | Deferred basis and gain from earlier exchanges may affect the current sale. |
The mortgage payoff statement is useful for estimating closing proceeds, but mortgage debt itself should not be mistaken for tax basis.
How Is Depreciation Recapture Reported to the IRS?
The sale of depreciated rental property commonly involves Form 4797, Sales of Business Property, along with the applicable Schedule D calculations.
IRS Publication 544 explains the treatment of Section 1231 property and depreciation recapture, while the Instructions for Form 4797 cover the reporting process.
Reporting can become more involved if the transaction includes Section 1245 assets, installment-sale treatment, a like-kind exchange, prior deferred gain or property that changed between personal and rental use.
That is why a generic online calculator should be treated as an estimate rather than the final tax return calculation.
The Bottom Line
The tax consequences of selling a rental property start with adjusted basis, not the property’s current equity.
Depreciation reduces basis throughout the holding period. At sale, part of a long-term gain may become unrecaptured Section 1250 gain subject to a maximum 25% federal rate, while other portions of the gain can receive different tax treatment.
Cost segregation can add another layer because some shorter-life assets may face Section 1245 recapture. A qualifying 1031 exchange may defer eligible gain. And if an investor wants liquidity rather than a complete exit, keeping the property and refinancing creates a different financial outcome that can be compared with the after-tax proceeds of selling.
Before closing, gather the depreciation schedule, basis records, improvement costs, cost segregation report if applicable, prior 1031 documentation and estimated selling expenses.
FAQs
What Is the Depreciation Recapture Tax Rate on a Rental Property?
For long-term gain attributable to depreciation on Section 1250 real property, the unrecaptured Section 1250 portion can be taxed at a maximum federal rate of 25%. That does not mean every investor automatically pays 25% on every dollar of accumulated depreciation.
Is Depreciation Recapture Based on Depreciation Claimed or Allowed?
The IRS generally requires basis to be reduced by depreciation allowed or allowable. If you could have claimed depreciation but did not, failing to take the deduction does not necessarily preserve that portion of your basis.
Does Land Have Depreciation Recapture?
Land itself is not depreciable. The purchase price or tax basis of a rental property must therefore be allocated between land and depreciable property.
Can You Avoid Depreciation Recapture by Not Claiming Depreciation?
Generally, no. IRS basis rules take into account depreciation that was allowed or allowable. Investors who have missed depreciation deductions should have their tax records reviewed rather than assuming the omitted deductions will prevent a basis reduction.
Does a 1031 Exchange Eliminate Depreciation Recapture?
A qualifying 1031 exchange can generally defer eligible gain rather than permanently eliminate it. The basis of the replacement property reflects the exchange rules, allowing deferred gain to carry forward.
Can Cost Segregation Increase Depreciation Recapture?
Cost segregation can change both the amount and character of depreciation involved in a later sale. Some shorter-life property can fall under Section 1245 and may have ordinary-income recapture, while the building itself generally follows Section 1250 rules.
Do You Pay Depreciation Recapture If You Sell a Rental Property at a Loss?
Depreciation recapture generally requires gain. A property sold at an overall loss does not simply generate depreciation recapture because depreciation was previously claimed. The calculation can still depend on individual assets, basis and the property’s tax history, particularly after cost segregation.
Does Paying Off the Mortgage Reduce Depreciation Recapture?
No. Mortgage balance and tax basis are different calculations. Paying down or paying off the loan changes the investor’s equity and cash proceeds, but it does not restore basis that was reduced by depreciation.
