When you sell a rental property at a gain, the IRS pulls back part of the tax benefit you got from depreciation. That portion of your profit, called depreciation recapture, is taxed at a federal rate of up to 25 percent, which is higher than the long-term capital gains rate that applies to the rest of the gain. Depreciation recapture when selling a rental property applies whether or not you actually claimed the deductions on your past returns, because the calculation uses the depreciation you were entitled to take.1Office of the Law Revision Counsel. 26 USC 1250 – Gain From Dispositions of Certain Depreciable Realty
How the Recapture Amount Is Figured
Your gain is the difference between what you receive at closing and your adjusted basis. Adjusted basis starts with the original purchase price plus closing costs like title insurance and legal fees, then adds capital improvements such as a new roof or replaced HVAC system, and finally subtracts every dollar of depreciation you took or should have taken.2Internal Revenue Service. Topic No. 703, Basis of Assets3Internal Revenue Service. Property (Basis, Sale of Home, etc.) 3
Once you have the gain, it splits into two pieces. The first piece equals the total depreciation you deducted (or were entitled to deduct) over the years — that is the recapture amount. The second piece is any remaining profit above your original purchase price, which is treated as regular long-term capital gain.
A worked example: you bought a rental for $300,000, of which $60,000 was land. You depreciated the $240,000 building over 27.5 years, taking about $8,727 a year, or roughly $87,270 across ten years of ownership.4Internal Revenue Service. Publication 527, Residential Rental Property5Internal Revenue Service. Topic No. 704, Depreciation With no capital improvements, your adjusted basis is $212,730. Sell for $350,000, and your total gain is $137,270. Of that, $87,270 is recapture and $50,000 is capital gain.
What Rate You Actually Pay
The recapture piece is taxed at a maximum federal rate of 25 percent.6Internal Revenue Service. Topic No. 409, Capital Gains and Losses If your ordinary bracket is lower, you pay at that lower rate instead. The remaining gain above your original purchase price is taxed at the standard long-term capital gains rates of 0, 15, or 20 percent, depending on your taxable income.7Office of the Law Revision Counsel. 26 USC 1 – Tax Imposed
Those preferential rates depend on holding the property more than one year. Sell inside a year and the whole gain becomes short-term, taxed at ordinary rates as high as 37 percent.
The 3.8 Percent Net Investment Income Tax
Higher-income sellers owe an additional 3.8 percent on top of the recapture and capital gains tax. Gain from investment real estate, including the recapture portion, counts as net investment income.8Internal Revenue Service. Questions and Answers on the Net Investment Income Tax It hits the lesser of your net investment income or the amount your modified adjusted gross income exceeds the threshold for your filing status: $200,000 single or head of household, $250,000 married filing jointly, $125,000 married filing separately. These thresholds do not adjust for inflation.9Internal Revenue Service. Topic No. 559, Net Investment Income Tax A large sale gain can push you over the line even in a year when your regular income sits well below it.
State Income Tax
Most states tax the gain and the recapture as ordinary income. Rates run from zero in states with no income tax to over 13 percent at the top. Some states do not mirror the federal preferential treatment, so the state bill can be a larger share of the total than you expect.
The “Allowed or Allowable” Trap
The recapture calculation uses the depreciation you were entitled to take, not just what you actually claimed.1Office of the Law Revision Counsel. 26 USC 1250 – Gain From Dispositions of Certain Depreciable Realty If you owned a rental for a decade and never depreciated it, the IRS still reduces your basis as if you had. You lose the past deductions and still owe the recapture tax.4Internal Revenue Service. Publication 527, Residential Rental Property
You can fix this before selling. File Form 3115 (Application for Change in Accounting Method) to switch to the correct depreciation method, and the cumulative missed depreciation comes back through a Section 481(a) adjustment in a single tax year.10Internal Revenue Service. Instructions for Form 3115 Amending old returns is not the route — the IRS requires the accounting method change instead. Filing Form 3115 before the sale is the only way to actually collect the deductions the IRS will recapture anyway.
Ways to Reduce, Defer, or Wipe Out the Recapture Bill
Release Suspended Passive Losses
Rental property is generally a passive activity, so losses that exceeded your passive income (outside the limited exception for taxpayers with AGI under $150,000) sat frozen on your returns. Disposing of your entire interest in the activity in a fully taxable sale releases every suspended loss, and those losses can then offset any type of income, including the recapture portion of the sale gain.11Office of the Law Revision Counsel. 26 USC 469 – Passive Activity Losses and Credits Limited Selling to a related party keeps the losses frozen until that party sells to an unrelated buyer.
1031 Like-Kind Exchange
A Section 1031 exchange defers both the capital gains tax and the depreciation recapture by rolling the proceeds into a replacement investment property. The old basis carries over, and the deferred gain surfaces when you eventually sell without exchanging again.12Internal Revenue Service. Like-Kind Exchanges Under IRC Section 1031 Two deadlines are strict: you must identify replacement properties in writing within 45 days of the sale, and close on the replacement within 180 days of the sale or by the due date (with extensions) of that year’s return, whichever comes first. A qualified intermediary must hold the funds; taking constructive receipt of the cash blows up the exchange and makes the full gain taxable.
Sell at a Loss
Recapture only applies when there is a gain. If the sale price falls below your adjusted basis, there is nothing to recapture. The loss is reported on Form 4797, combined with other business property gains and losses for the year, and treated as an ordinary loss if the net result is negative, sidestepping the $3,000 annual capital-loss limit.13Internal Revenue Service. Sale or Trade of Business, Depreciation, Rentals
Inherit Instead of Sell
When a rental owner dies, the heir’s basis resets to fair market value on the date of death, and all prior depreciation is effectively erased.14Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired From a Decedent A sale at or near the stepped-up value produces little or no gain and no recapture. The heir starts a fresh depreciation schedule on the new basis (minus land) and begins accumulating a new potential recapture obligation from there.
A Boundary Worth Knowing: The Home-Sale Exclusion Does Not Cover Recapture
If you lived in the home as your primary residence and later rented it, the Section 121 exclusion of up to $250,000 of gain ($500,000 married filing jointly) may cover part of your profit, provided you owned and used the home as your main residence for at least two of the five years before sale. The exclusion does not shelter gain equal to the depreciation you took (or could have taken) after May 6, 1997 — that piece is still recaptured at the 25 percent rate.15Internal Revenue Service. Selling Your Home Rental use after 2008 also counts as “nonqualified use,” and a proportional share of the non-recapture gain is ineligible for the exclusion.
An Installment Sale Does Not Defer the Recapture
Spreading the sale over multiple years does not spread the recapture tax. The capital gains portion can be reported as payments come in, but depreciation recapture is fully taxable in the year of sale, even if you receive no cash that year.16Internal Revenue Service. Publication 537, Installment Sales The recapture is computed in Part III of Form 4797, and only the gain above that amount goes on Form 6252.17Internal Revenue Service. Form 6252, Installment Sale Income
Forms to File in the Year of Sale
Reporting the sale runs through three forms filed with your federal return for the year the sale closes.
- Form 4797 (Sales of Business Property) is the main form. Part III determines how much of the gain is treated as recapture.18Internal Revenue Service. Instructions for Form 4797
- Schedule D (Capital Gains and Losses) receives the long-term capital gain portion from Form 4797 and combines it with your other capital gains and losses.
- Form 8949 reports the excess of the total gain over the recapture amount before it flows to Schedule D.
Each of these needs the gross sale price, adjusted basis, and total depreciation taken or allowable. Late filing or missing forms brings penalties and interest on any unpaid balance.