Depreciation Recapture: The Tax Bill That Comes Due When You Sell

Think of depreciation as an interest-free loan from the government. Each year you own a rental, you deduct a slice of the building's cost against your rental income, and each deduction reduces the property's basis. When you sell for more than that reduced basis, the IRS collects on the loan: the portion of your gain created by depreciation is taxed under the recapture rules rather than at the friendlier long-term capital gains rates.

Recapture hits in the year of a taxable sale, and only when there is a gain. It is calculated on Form 4797 and flows from there to your return. No sale, no recapture. Sell at a loss, no recapture either (more on that in the FAQ). What you cannot do is escape it by simply never claiming the deduction.

The building itself is Section 1250 property. Because real property placed in service after 1986 is depreciated straight line, there is usually no ordinary-rate recapture on the structure. Instead, the straight-line depreciation reflected in your gain becomes unrecaptured Section 1250 gain, taxed at your ordinary rate but capped at 25%.

Everything a cost segregation study carves out of the building (appliances, carpet, cabinetry, fences, parking, landscaping) is Section 1245 property. Gain on those assets is ordinary income to the extent of the depreciation you took on them, with no rate cap. This is the trap cost segregation critics point to: the same bonus depreciation that produced a large deduction at your marginal rate comes back at your marginal rate if you sell the assets at a gain. Whether that trade still works for you is a math question, and we walk through it honestly in section 5.

One nuance worth knowing: Section 1245 recapture is limited to the lesser of the depreciation taken on an asset or the actual gain on that asset. A seven-year-old carpet that sells for next to nothing produces little or no recapture, no matter how much bonus depreciation it generated. That detail drives the allocation planning covered in section 4.

Take a hypothetical investor who bought a rental for $400,000, ran a cost segregation study, took $120,000 of total depreciation over about seven years, and now sells for $650,000. Round, illustrative numbers; results vary with your facts.

Step 1: Find the adjusted basis.

Step 2: Find the total gain.

Step 3: Split the gain into its tax layers.

The sale contract allocates $50,000 to the cost seg assets, so their full $50,000 of bonus depreciation is recaptured as ordinary income. The $70,000 of straight-line depreciation on the building becomes unrecaptured Section 1250 gain at the 25% cap. The remaining $250,000 is ordinary long-term capital gain. Because this seller's income is well over the $250,000 married filing jointly threshold, the 3.8% net investment income tax applies to the gain as well.

Notice the shape of that bill. The "capital gains" line most sellers plan for is $37,500. The recapture layers and NIIT add roughly $47,500 on top, more than doubling it. That is why we model the exit before a client lists, not after.

1. The 1031 exchange

The primary tool. Roll the sale proceeds into like-kind replacement real estate through a qualified intermediary and both the capital gain and the recapture are deferred, not forgiven, into the new property. You can exchange repeatedly. One caution for cost-segregated properties: since 2018, Section 1031 applies only to real property, so components your study classified as personal property need careful handling in the exchange documents. Our 1031 exchange guide covers the deadlines and mechanics.

2. Hold until the basis steps up

Under current law, heirs generally receive inherited property at its fair market value on the date of death. All of the deferred depreciation, including everything rolled forward through prior 1031 exchanges, is wiped from the basis math. This is why long-term investors talk about never selling. To be clear: this is an estate planning outcome that has to fit your actual life and liquidity needs, not a quick tax move, and the rules could change. It belongs in a plan, not a slogan.

3. Installment sales (know the trap)

Seller financing spreads the capital gain over the years you collect payments, which can keep the 15% versus 20% brackets in check. But the ordinary recapture portion does not spread: any Section 1245 (or Section 1250 ordinary) recapture is reported in full in the year of sale, even if you received no payment that year. On a heavily cost-segregated property, an installment sale can create a year-one tax bill with no cash to pay it. The unrecaptured Section 1250 layer is also recognized ahead of the lower-rate gain as payments arrive.

4. Partial disposition elections along the way

When you replace a roof, HVAC, or other structural component, you can elect to recognize a loss on the retired component and remove its remaining basis from the depreciation schedule. You get a deduction now, and you stop depreciating an asset that no longer exists, which trims the depreciation pile waiting to be recaptured at sale.

5. Asset-by-asset planning before the sale

Because Section 1245 recapture is capped at the actual gain on each asset, the purchase price allocation in your sale contract matters. Worn-out five-year property is rarely worth its original cost at sale, and a defensible allocation that reflects that reality shrinks the ordinary-rate layer. This is a before-the-contract-is-signed conversation with your CPA, not a tax-prep-season cleanup.

We sell cost segregation studies, so take this section as the disclosure it is: cost seg is a timing and character trade, and there are fact patterns where it loses.

The favorable case is easy to see. A $50,000 bonus depreciation deduction at a 37% bracket saves $18,500 today. Hold the property a decade, exchange or hold until death, and much of that recapture is deferred indefinitely while you had years of use of the cash.

Now run the short hold. Same $50,000 deduction, same $18,500 saved, but you sell in a taxable sale two years later with the assets still holding value. The Section 1245 recapture claws back up to that same ordinary-rate tax, you paid several thousand dollars for the study, and you got only two years of use of the money. If your bracket went up in between, you repay at a higher rate than you deducted at. The net can easily be negative.

Cost seg tends to be the wrong call when:

• You expect a taxable sale within roughly two to three years and a 1031 is unlikely.
• Your current bracket is low but the sale-year bracket will be high.
• The losses would just sit suspended as passive losses you cannot use, while the recapture clock runs anyway.

It tends to be the right call for long holds, exchange-and-hold investors, and owners who can actually use the losses now, such as those with short-term rental losses that qualify as nonpassive or real estate professional status. The point is that the exit plan decides, so decide the exit before you commission the study.

• Cost segregation: the accelerated-depreciation strategy that creates the Section 1245 exposure discussed above.
• 1031 exchange: the primary tool for deferring both recapture and capital gains.
• Capital gains tax strategies: how the 0%, 15%, and 20% brackets work and how to plan around them.
• Capital gains tax calculator: estimate your own sale before you talk to anyone.
• Sell or rent your house: why converting a primary residence to a rental starts this exact recapture clock.
• Real estate strategy hub: every real estate tax strategy we cover, in one place.