Depreciation recapture on rental property: a worked example

What depreciation recapture is

When you own a rental, the IRS lets you deduct the building's cost a little each year. For a residential rental that is spread over 27.5 years. The deduction lowers your taxable rental income while you own the place.

The catch comes at the sale. Every dollar of depreciation also lowers your basis, so your taxable gain grows by the same amount. The part of the gain that comes from depreciation is called unrecaptured section 1250 gain. It is taxed at your ordinary rate, but never more than 25%. The rest of the gain is a regular long-term capital gain.

Not tax advice. This page walks through a simplified federal estimate with a flat state rate. Your real bill depends on your whole return, so run it past a CPA or tax advisor before you list.

The math, step by step

1. Depreciation. Building value (purchase price plus improvements, minus land) ÷ 27.5 × years owned. Use the real number from your returns if you have it.

2. Adjusted basis. Purchase price + improvements − depreciation.

3. Gain. Sale price − selling costs − adjusted basis.

4. Recapture tax. The smaller of the gain and the depreciation, times your bracket, capped at 25%.

5. Capital gains tax. The rest of the gain times 0%, 15%, or 20%, based on your taxable income.

6. Extras. The 3.8% net investment income tax if your income is high enough, and your state's tax on the gain.

Example

Illustrative example. These are the same sample numbers loaded in the keep or sell rental calculator, so you can follow along. You bought a rental 8 years ago for $250,000 and put $20,000 into improvements. The county splits $50,000 of that to land. It is worth $400,000 today, selling costs run 7%, and you owe $160,000. You are in the 24% bracket, pay 15% on long-term gains, and your state charges 5%.

Depreciation. The building is $220,000, so you get $8,000 a year. Eight years is $64,000. Your adjusted basis is $270,000 − $64,000 = $206,000.

Gain. Selling costs are $28,000, so the amount realized is $372,000. The gain is $372,000 − $206,000 = $166,000.

Tax. The first $64,000 of gain is recapture at 24%: $15,360. The other $102,000 is taxed at 15%: $15,300. State tax at 5% of the gain is $8,300. Total tax: $38,960, about 23.5% of the gain.

Cash in hand. $372,000 − the $160,000 payoff − $38,960 of tax = $173,040. If you also owe the 3.8% NIIT on the whole gain, add $6,308 of tax and you walk away with $166,732.

NIIT generally doesn't apply to a rental gain if you qualify as a real estate professional who materially participates in the rental (see the IRS Form 8960 instructions).

Keep or sell. Say you keep it 5 more years. At 3% a year it is worth about $463,710. The loan drops to about $134,876. You collect $6,000 a year of cash flow, $30,000 in all. Depreciation keeps running, so the later sale recaptures $104,000 and the tax rises to about $62,410. You end with $263,964. Sell today and invest the $173,040 at 7% a year, and you end with $242,698. Keeping comes out $21,267 ahead.

How close is it? Selling wins if the cash earns more than about 8.81% a year. Keeping wins as long as the house grows faster than about 1.70% a year. Two guesses decide the answer, so test both.

Why the 25% cap matters

In the 22% or 24% bracket, recapture is taxed at your bracket. Above that, the 25% cap kicks in. In the 35% bracket, $100,000 of recapture costs $25,000, not $35,000.

Recapture is still usually taxed higher than the rest of the gain. That is why owners are often surprised: the gain they expected to pay 15% on is partly taxed at up to 25%.

Options besides a straight sale

A 1031 like-kind exchange lets you roll the proceeds into another investment property and defer the tax, if you follow strict deadlines and use a qualified intermediary (IRS Form 8824). An installment sale spreads the gain over the years you collect payments, though recapture rules still apply. Selling in a lower-income year can drop your capital gains rate or keep you under the NIIT threshold.

Each of these has rules and trade-offs that depend on your situation. They are options to raise with your CPA, not a recommendation.

IRS sources

IRS Publication 544, Sales and Other Dispositions of Assets: gain, basis, and depreciation recapture, including the allowed-or-allowable rule. IRS Publication 527, Residential Rental Property, and Publication 946, How to Depreciate Property: the 27.5-year recovery period. IRS Tax Topic 409, Capital Gains and Losses: the 0%, 15%, and 20% rates and the 25% maximum on unrecaptured section 1250 gain. Form 8960 and Tax Topic 559: the 3.8% net investment income tax and its $200,000 single and $250,000 married filing jointly thresholds.

Common pitfalls

Skipping depreciation to dodge recapture. It does not work. Your basis drops by the depreciation you could have taken, so you pay recapture without ever getting the deduction.

Forgetting improvements. A new roof or kitchen adds to basis, which lowers the gain, but it also gets depreciated, so it adds to recapture too.

Comparing keep vs. sell without the later tax. Holding longer means more depreciation and usually a bigger gain, so the tax bill at the end is larger, not the same.

Using one appreciation guess. Run a low case. In the example, growth under about 1.70% a year flips the answer to sell.

Forgetting suspended passive losses. Losses you couldn't deduct in earlier years are generally released when you sell the whole property to an unrelated buyer, which can offset part of the tax. This calculator doesn't include them (IRS Publication 925).

Questions