Key takeaways
- Partly. A long term capital loss carryforward reaches the building portion of depreciation recapture and does not reach the equipment portion.
- Unrecaptured section 1250 gain stays long term capital gain, in its own bucket taxed at up to 25%, so capital losses net against it.
- Section 1245 recapture is ordinary income. Capital losses cannot offset ordinary income beyond the small annual allowance.
Model the sale before you sign
The split between the two buckets is set by how the property was depreciated, and it is knowable in advance.
You get the answer from the character of each piece of gain, and the size of your loss does not change it.
Which part of the gain you can offset with a capital loss carryforward
The more aggressively a property was depreciated, the more of the eventual gain sits on the right hand side, where the carryforward cannot help.
You bring the depreciation you took on the building back as unrecaptured section 1250 gain, which stays long term capital gain, and the IRS taxes it in a category capped at 25%. Because you still hold capital gain, you run it through the ordinary capital netting and you reduce it with your capital losses.
You bring the depreciation you took on section 1245 components back as ordinary income, and you cannot offset it with a capital loss carryforward. You offset ordinary income with capital losses only up to the small annual allowance, and you apply a carryforward against capital gains first.
How to tell which bucket a component belongs in
Go by how the component attaches to the building and how permanently someone designed it to stay there, not by its recovery period. A five year fixture is section 1245 property. A fifteen year land improvement can fall on either side, which is why the recovery period cannot tell you the answer.
How to offset the section 1245 half
You cannot offset section 1245 recapture with a capital loss, and you may be able to offset it with suspended passive losses on the property. The IRS releases those losses against the gain from that activity first, and the recapture is part of that gain.
- Full disposition.You have to dispose of your entire interest in the activity. Where you grouped several properties into one activity, you free nothing by selling one of them.
- Related buyers.Sell to a spouse, child, sibling, parent or an entity you control and the IRS freezes the losses until an unrelated buyer takes the interest.
- What counts as fully taxable.A foreclosure, a deed in lieu, a short sale and an abandonment each count. A 1031 exchange and a contribution to a partnership do not.
- Installment sales.You free the losses in the same proportion as the gain you recognize each year, so you schedule the deduction instead of losing it.
- Death.Your heirs lose any suspended losses above the basis step-up.
- Order of work.We check your suspended loss balance before modeling the sale, because you may be able to cover part of the section 1245 half with it.
A worked example on a $400,000 gain
Assume a long term holding period, no other gains or losses in the year, and no prior section 1231 losses.
You sell a rental at a gain of $400,000. You took $150,000 of depreciation on the building and $60,000 on components you moved to short lives with a cost segregation study, and you hold a $100,000 long term capital loss carryforward.
- You bring $60,000 back as section 1245 ordinary income, and you cannot use the carryforward against it.
- $150,000 is unrecaptured section 1250 gain in the 25% category, and you can use the carryforward against it.
- The remaining $190,000 is long term capital gain.
You apply the $100,000 carryforward through the netting rules, and the IRS applies it to the higher taxed capital categories before the lower ones, so you get the most from it against the 25% category. You get nothing from it against the $60,000.
Why cost segregation changes the capital loss carryforward answer
The more you accelerate, the less of your eventual gain you can offset with a capital loss carryforward.
You move basis out of the building and into five, seven and fifteen year assets when you commission a study. You get those deductions faster, and you give back the ones on section 1245 components at ordinary rates instead of inside the capped category. Plan the study and the sale together if you hold a carryforward and expect to sell.
The study side is covered on cost segregation for short term rentals.
What you can spread over an installment sale
The IRS makes you recognize section 1245 recapture in full in the year of sale, whatever cash you have collected, and you spread only the gain above it over the payments.
- Section 1245 recapture.Ordinary income, all of it in year one, with no spread.
- Unrecaptured section 1250 gain.You spread this over the payment years, and you take it before your other long term capital gain.
- Long term capital gain.You take this last, as the payments come in.
You can owe more ordinary income tax in year one than you collect at closing, on a property you accelerated heavily. You report the recapture on Form 4797 in the year of sale, not on Form 6252 as the payments arrive.
What else changes the answer
- A 1031 exchange:You defer the whole gain, recapture included, and you carry the depreciation history into the replacement property. The IRS keeps any suspended passive losses frozen as well.
- Selling at a loss:You have no gain to recapture, and you report a section 1231 loss on business or rental property, which the IRS treats as ordinary.
- The section 1231 five year lookback:Where you claimed net section 1231 losses in the previous five years, the IRS recharacterizes that much of this year’s gain as ordinary income.
- Net investment income tax:You pay this on top above the income thresholds, at a maximum of 28.8% on unrecaptured section 1250 gain and 40.8% on section 1245 recapture.
- Holding until death:Your heirs take a stepped up basis and no recapture carries over to them. They also lose any suspended passive losses above that step-up.
You may find any of these changes your answer more than the carryforward does.
What modeling a sale costs
Priced on the property and the schedule behind it. What it depends on:
- Whether a full depreciation history exists or has to be rebuilt
- Whether a cost segregation study was done and how the components were split
- Whether an exchange or an installment sale is being considered
- Number of properties disposed of in the same year
These are the factors, not a quote.
Why use us to model a sale
Our licensed CPAs and Enrolled Agents model the sale while you can still change the outcome. After closing we would only be reporting it.
You just sold a home and you know you have capital gains. You just got married and you don’t know what your taxes are going to look like with your spouse. You just had a child and you don’t know how that’s going to impact your taxes. You just made a big purchase or you made a big sale in cryptocurrency or equity or stock. You don’t know how that will affect your taxes. Plan early because if you don’t there might be a surprise.
George Dimov, CPA · Founder, Dimov Tax
I’ve worked with them on my state and federal taxes and the sale of a condo. They gave clear and thoughtful advice each time. I wouldn’t work with anyone else.
Nandu · Washington, DC · Yelp review
This page is general information rather than advice for your circumstances. Outcomes turn on facts specific to you, so speak to a CPA before acting on anything here.
Run the numbers before the closing date
Once you close, the character of each dollar is fixed. Before you close, you still have choices.