How Rental Property Depreciation Recapture Works

When you sell a rental property for a profit, the Internal Revenue Service (IRS) has a method to tax the depreciation deductions you claimed over the years, a process known as depreciation recapture. Depreciation deductions lower your taxable income each year you own the property, but they also reduce your property’s cost basis. This reduction in basis is a key factor in calculating your taxable gain upon sale.

The recapture tax is not a penalty, but rather a way to account for the gain that results directly from the depreciation deductions. If you sell a property for more than its depreciated value, the IRS requires a portion of your profit to be taxed differently to balance out the tax benefit you received during ownership.

The “Allowed or Allowable” Depreciation Rule

A core concept in depreciation recapture is the “allowed or allowable” rule. This principle means the IRS calculates your gain and subsequent recapture tax based on the amount of depreciation you were entitled to take, not necessarily the amount you actually claimed. The tax code requires you to reduce your property’s basis by the depreciation you could have taken each year.

For example, if you owned a rental property for ten years but never claimed the annual depreciation deduction, you are still treated as if you had. When you sell the property, the IRS will still require you to calculate your taxable gain as if you had taken those deductions. This increases your taxable gain and can lead to a tax on a benefit you never actually received.

Calculating the Depreciation Recapture Tax

The calculation of the depreciation recapture tax separates different types of gains, which are taxed at different rates. Assume you purchased a residential rental property for $350,000, with the building valued at $275,000 and the land at $75,000. Over a decade, you correctly claimed $100,000 in depreciation deductions and then sell the property for $500,000.

First, you must determine your adjusted cost basis. This begins with the original purchase price ($350,000) and is reduced by the total depreciation you were allowed or took ($100,000). This leaves you with an adjusted cost basis of $250,000.

Next, you calculate the total gain on the sale by subtracting the adjusted cost basis from the sale price. In this case, the total gain is $250,000 ($500,000 sale price – $250,000 adjusted cost basis). This total gain is composed of the depreciation recapture amount and the remaining capital gain.

The portion of the gain attributable to depreciation is the lesser of either the total depreciation taken ($100,000) or the total gain ($250,000). Here, the amount to be recaptured is $100,000. For depreciation claimed on the rental building itself, this gain is taxed at a maximum federal rate of 25%.

However, if a portion of the depreciation was for personal property—such as appliances or carpeting—that amount is taxed at the owner’s ordinary income tax rate, which can be as high as 37%.

Finally, any gain that remains after accounting for the recaptured depreciation is treated as a standard long-term capital gain. To find this amount, you subtract the recaptured gain from the total gain: $250,000 – $100,000 equals $150,000. This remaining $150,000 is subject to the long-term capital gains tax rates, which are 0%, 15%, or 20%, depending on your overall taxable income.

Reporting the Sale on Your Tax Return

Once you have calculated the total gain, you must report the transaction correctly on your federal tax return. The primary form for this purpose is IRS Form 4797, Sales of Business Property, which is designed for assets used in a trade or business, including rental properties.

The key section for reporting the sale is Part III. Here you will detail the sale, including the original cost, the depreciation allowed or allowable, and the sale price. The form guides you through the calculation to separate the gain attributable to depreciation from the remaining capital gain.

After completing Form 4797, the results are transferred to other parts of your tax return. The gain attributable to depreciation and the remaining long-term capital gain are carried to Schedule D (Capital Gains and Losses), ensuring each portion of the gain is taxed at the correct rate.

Deferring Depreciation Recapture with a 1031 Exchange

Investors can postpone the tax liability from both depreciation recapture and capital gains using a Section 1031 “like-kind” exchange. This provision in the tax code allows you to sell an investment property and reinvest the entire proceeds into a new, similar property without immediately triggering a tax event. By properly structuring the transaction, the recognition of the gain is deferred.

The mechanics of a 1031 exchange are subject to strict timelines. From the day you close the sale of your original property, you have 45 days to formally identify potential replacement properties. You must then close on the purchase of one or more of those identified properties within 180 days of the original sale.

To comply with IRS regulations, the exchange must be facilitated by a Qualified Intermediary, as you cannot have actual or constructive receipt of the sale proceeds. While the 1031 exchange is an effective deferral strategy, the tax liability does not disappear. The deferred gain, including the depreciation recapture amount, is carried over to the new property to be recognized in a future taxable sale.