How to Avoid Depreciation Recapture Tax on Rental Property

Selling rental property involves navigating tax rules, especially those related to depreciation. Depreciation recapture tax applies to the gain from selling property that has been depreciated, reclaiming tax benefits from past deductions. For rental property owners, understanding this tax and how to defer or reduce it is a significant aspect of financial planning. This overview clarifies depreciation recapture and highlights available strategies.

Understanding Depreciation Recapture

Depreciation is a tax deduction allowing property owners to recover an asset’s cost over its useful life, reflecting wear and tear. For rental properties, only the building structure is depreciable, not the land. Annual depreciation deductions reduce the property’s tax basis.

When a rental property is sold for a gain, a portion may be subject to depreciation recapture, applying to the gain representing previously deducted depreciation. The Internal Revenue Service (IRS) taxes this portion as “unrecaptured Section 1250 gain” at a maximum rate of 25%, a rate distinct from lower long-term capital gains rates. The amount subject to unrecaptured Section 1250 gain is the lesser of the total gain or total depreciation taken. For properties placed in service after 1986, only straight-line depreciation is allowed for real estate, simplifying recapture calculation.

Specific Strategies to Defer or Reduce Recapture

Like-Kind Exchange (1031 Exchange)

A significant strategy for deferring both capital gains and depreciation recapture taxes is the Like-Kind Exchange, under Section 1031 of the Internal Revenue Code. This provision allows an investor to postpone gain recognition on the sale of investment property if proceeds are reinvested into another “like-kind” property. The deferral applies to both capital gain and depreciation recapture.

To qualify, strict rules and timelines must be followed. The relinquished and replacement properties must be “like-kind,” meaning they are of the same nature or character, such as real estate held for investment. A qualified intermediary (QI) is required to facilitate the exchange, holding sale proceeds to prevent direct access.

There are two critical timeframes: the 45-day identification period and the 180-day exchange period. Investors have 45 calendar days from the sale date to identify potential replacement properties in writing. The replacement property must be acquired within 180 days from the sale date. Both deadlines run concurrently.

Installment Sale

An installment sale allows managing tax liability, including depreciation recapture, by receiving at least one payment after the tax year of sale. This approach spreads the recognition of gain and tax liability over multiple tax years as payments are received. The installment method applies automatically unless the seller elects out.

A portion of each payment is considered a return of basis, a portion is recognized as capital gain, and any interest is reported as ordinary income. The depreciation recapture portion of the gain is recognized proportionally with each payment. Utilizing an installment sale can help align tax payments with cash flow, preventing a large tax bill in a single year. This can benefit sellers who do not need immediate access to all proceeds or anticipate being in a lower tax bracket later.

Converting Rental Property to a Primary Residence

Converting a rental property into a primary residence before selling can offer a way to exclude a portion of the gain under Section 121 of the Internal Revenue Code. For this exclusion, the owner must have owned and used the home as their main residence for at least two of the five years before the sale. The two years of residency do not need to be consecutive.

Qualifying taxpayers can exclude up to $250,000 of gain for single filers and up to $500,000 for married filing jointly. However, this exclusion does not apply to the portion of the gain from depreciation taken after May 6, 1997. This specific amount of depreciation is still subject to recapture as unrecaptured Section 1250 gain, even if the rest of the gain is excluded.

Reporting Depreciation Recapture on Your Tax Return

When selling a rental property, details of the sale and any associated depreciation recapture are reported on IRS Form 4797, Sales of Business Property. This form is used for the sale or exchange of property used in a trade or business, including rental real estate. Part III of Form 4797 is used to figure the amount of ordinary income recapture, including unrecaptured Section 1250 gain.

The calculated unrecaptured Section 1250 gain from Form 4797 then flows to Schedule D, Capital Gains and Losses, where it is reported and taxed at the maximum rate of 25%. Any remaining gain on the sale is reported on Schedule D and taxed at applicable long-term capital gains rates.

For 1031 exchanges, gain, including depreciation recapture, is generally not recognized on the current year’s tax return. Instead, the tax basis of the new property is adjusted to reflect the deferred gain. For installment sales, Form 6252, Installment Sale Income, is used to report the sale and subsequent payments, with information flowing to Form 4797 and Schedule D.