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Each year, depreciation reduced your basis and may have cut your taxable income. When you sell, some of that gain is ordinary income and some is taxed at up to 25 percent.
The gain split correctly, between ordinary income, the up to 25 percent slice, and what is left
Recapture tax modeled before the closing date, while the deal can still be structured
Form 4797 prepared with the return, so the numbers tie to the depreciation schedule
Recapture is measured on the depreciation you were allowed to take, whether or not you claimed it. Skipping depreciation on a rental does not protect you at sale.
Depreciation lowered your basis and may have cut taxable income while you held the asset. So the gain at sale is larger than the cash profit suggests, and some of it is ordinary income or taxed at up to 25 percent.
The number turns on three things, in order: the kind of property, the depreciation allowed or allowable, and what happens to the gain left after recapture.
Where the work is. The calculation is arithmetic; the classification is the judgment call.
The same building can hold section 1245 property and section 1250 property at once, and a cost segregation study makes that split larger in both directions. Components moved into 5, 7 or 15 year classes by the study are section 1245 property. The section 179 expense and bonus depreciation taken on them come back as ordinary income at sale, so the study buys timing at the cost of a rate.
Land has no depreciation and no recapture, so part of this bill was fixed by the purchase price allocation you made years ago.
Three code sections set the rules, and Publication 544 explains each. Sections 1245 and 1250 are about different property, and section 1231 is for what is left after recapture.
| Section | What property | How the gain is taxed |
|---|---|---|
| Section 1245 | Equipment, vehicles, fixtures, personal property | Comes back as ordinary income, up to the gain |
| Section 1250 | Buildings and structural components | Only depreciation above straight line, so usually nothing |
| Section 1231 | Gain left after recapture and netting | Capital treatment, subject to the five year lookback |
Section 1231 property is depreciable business property and business real estate held more than a year, so the assets above are section 1231 property as well as 1245 or 1250 property.
Recapture is only for gains. A sale at a loss produces a section 1231 loss and no recapture.
The middle row is usually zero. Real property placed in service after 1986 must use straight line, so there is no excess depreciation to recapture.
The depreciation does not escape. It becomes unrecaptured section 1250 gain, taxed at up to 25 percent.
This line is what a rental sale costs. On section 1250 real property the depreciation related gain is generally unrecaptured section 1250 gain, taxed at a maximum 25 percent rate. The rate you pay depends on taxable income.
One sale, two tax rates
Bought 400,000. Depreciation 100,000. Sold 520,000.
Take a rental bought for 400,000 dollars and sold for 520,000 after 100,000 of depreciation, with no other section 1231 items or lookback losses.
| Line | Amount |
|---|---|
| Purchase price | 400,000 dollars |
| Depreciation taken | 100,000 dollars |
| Adjusted basis | 300,000 dollars |
| Sale price | 520,000 dollars |
| Total gain | 220,000 dollars |
| Unrecaptured section 1250 gain, up to 25 percent | 100,000 dollars |
| Section 1231 gain, long term capital rates | 120,000 dollars |
On those figures, budgeting the entire gain at 15 percent understates the federal bill by up to 10,000 dollars. That figure belongs in the decision before closing.
It is computed on the Schedule D worksheet, not on the face of the return. That is why we review self prepared rental sales before anything else.
The time for this conversation is before the closing date, while the structure is still open. Afterwards it is arithmetic, and we are reporting what already happened.
Send the closing statement and the depreciation schedule from your last return. We tell you what the sale costs before you sign anything.
Recapture can be deferred, shifted or eliminated, and some routes assumed to help do not.
| Approach | What it does | Watch for |
|---|---|---|
| 1031 exchange | Can defer gain on qualifying real property | Cash or boot can still be taxable now |
| Installment sale | Spreads capital gain, not 1245 recapture | Section 1245 recapture is taxed in the year of sale |
| Holding until death | Basis steps up, recapture disappears | No timing to control |
| Home sale exclusion | Leaves depreciation out | Depreciation after May 6, 1997 remains taxable |
The 1031 row narrowed in 2018. Since the 2017 Act it is limited to real property, so the section 1245 equipment in the first table no longer qualifies.
Installment sale depreciation recapture has its own rule. On section 1245 property the recapture is taxed in the year of sale in full, whatever the payment schedule says.
On a rental the 25 percent slice does spread, but it comes out of the early payments first.
Nonrecaptured section 1231 losses come first. Net section 1231 losses in the previous five years turn this year’s section 1231 gain back into ordinary income to that extent. We check that before anything is reported on Schedule D.
Basis is reduced by the depreciation you took or could have taken. A landlord who did not claim depreciation still has the reduced basis at sale, and still owes the recapture.
There is a fix for the missed years: a change in accounting method on Form 3115, which has its own page. Start it before a sale.
Send the depreciation schedule from the last return, the original closing statement and the improvement history.
We classify the components, separating section 1245 items from the section 1250 building.
We rebuild the adjusted basis using depreciation allowed or allowable, including any section 179 and bonus.
We split the gain and check the five year lookback before anything is treated as capital.
We give you the number, and where the sale has not closed, the options that change it.
We prepare Form 4797 with the return and tie it back to the schedule.
We work with clients in all 50 states by video and phone. Where a cost segregation study was done, that report is part of step two.
Reporting is quoted with the return and its rental or business schedules. A pre closing projection is quoted separately. These are the factors, not a quote.
A pattern on rental sales. The owner has modeled the gain at the long term capital rate and built the next purchase around that figure.
The depreciation slice at up to 25 percent was not in the model, and on a property held ten years it can exceed the capital gain itself.
We rebuild the depreciation schedule from the returns before quoting anything, because the number in the client’s head and the number on the schedule are rarely the same.
Everyone is great. I would always owe money on taxes and now I get a refund. They do things like depreciation for example that my CPA’s in past did not do.
Our team includes CPAs and Enrolled Agents who work on individual returns, business taxes and tax planning. Tell us what you need help with when you get in touch.
After closing, the law is rarely the problem. One number is, and by then the only question left is how to pay it.
Before the sale there are choices. After it there is a return.
General rules only, not advice on your situation. Classification and basis turn on facts we have not seen, so speak to a CPA or an Enrolled Agent before a sale.
