When Do Capital Gains, Depreciation Recapture & Transfer Taxes Apply?

When selling or transferring assets like real estate, three distinct taxes can apply: capital gains tax, depreciation recapture, and transfer taxes. A capital gains tax is levied on the profit realized from selling an asset. Depreciation recapture is a separate tax that recoups the tax benefits a taxpayer received from depreciating an asset. Transfer taxes are imposed by state or local governments for changing a property’s legal ownership. These taxes are not mutually exclusive and can apply to the same transaction.

Application of Capital Gains Tax

Capital gains tax applies when a gain is realized from the sale of a capital asset. A capital asset includes most property you own for personal use or investment, such as stocks, bonds, and real estate.

A taxable gain exists when an asset is sold for more than its adjusted basis. This basis starts as the original purchase price but is increased by the cost of capital improvements, like a new roof, and decreased by any depreciation deductions claimed. For example, buying a property for $300,000 and adding a $50,000 extension results in an adjusted basis of $350,000.

The holding period determines if a gain is short-term or long-term. If an asset is owned for one year or less before being sold, the profit is a short-term capital gain and is taxed at the owner’s ordinary income tax rates, which range from 10% to 37%.

If the asset is held for more than one year, the profit is a long-term capital gain. These gains are subject to more favorable tax rates, which for 2025 are 0%, 15%, or 20%, depending on the taxpayer’s filing status and total taxable income.

A significant exception to capital gains tax applies to the sale of a primary residence. This rule allows an individual to exclude up to $250,000 of gain, and this amount doubles to $500,000 for a married couple filing a joint return. To qualify, the taxpayer must meet both an ownership test and a use test. The tests require that you have owned the home and used it as your principal residence for at least two of the five years ending on the date of the sale. The two years of use do not need to be consecutive.

Application of Depreciation Recapture

Depreciation recapture applies when a depreciable asset used for business or investment is sold for a gain. Its purpose is to recapture the tax benefit received from depreciation deductions. These deductions lower your ordinary taxable income while you own the property, and recapture ensures a portion of the gain on sale is taxed to account for that benefit.

The tax is triggered only on the part of the gain attributable to the depreciation taken. The portion of your gain that equals the total depreciation claimed is the amount subject to recapture.

Consider a rental property purchased for $400,000. Over several years, you claim $100,000 in depreciation deductions, which reduces your adjusted basis to $300,000. If you then sell the property for $450,000, your total gain is $150,000; the first $100,000 is depreciation recapture, and the remaining $50,000 is a capital gain.

The tax rate for this recaptured amount differs from a standard capital gain. For real property, this gain is known as “unrecaptured Section 1250 gain” and is taxed at a maximum federal rate of 25%. This rate is higher than the 0% or 15% long-term capital gains rates but is lower than most ordinary income tax rates. Any gain above the recaptured amount is treated as a regular long-term capital gain.

Application of Transfer Taxes

Transfer taxes are different from income-based taxes like capital gains. The trigger for a transfer tax is the legal conveyance of property ownership recorded via a deed. This tax applies regardless of whether the seller realized a profit or a loss, as it is a tax on the transaction itself.

These taxes are not a federal levy but are imposed at the state, county, or municipal level. Because of this, the rules, rates, and exemptions vary significantly by location. The tax is calculated as a percentage of the property’s sale price.

These taxes are known by several names, such as “real estate transfer tax,” “deed transfer tax,” or “documentary stamp tax.” The name used often depends on the terminology adopted by the state or local government.

Another practical aspect that varies by location is determining who is responsible for paying the tax. In some areas, it is customary for the seller to pay the entire transfer tax, while in other regions, the buyer is responsible. In many jurisdictions, the cost is split between the buyer and seller, which can be a negotiable item within the sales contract.

Special Transactions and Their Tax Implications

Certain transactions alter the standard application of capital gains and depreciation recapture taxes. One of the most common for real estate investors is a like-kind exchange. This provision allows an investor to sell a business or investment property and defer paying taxes on the gain if the proceeds are reinvested into a similar property. The tax is not eliminated but is postponed, allowing the investment to grow without an immediate tax reduction.

To execute a like-kind exchange, an investor must identify a potential replacement property within 45 days of selling their original property. The purchase must then be completed within 180 days of the original sale. This deferral applies to both capital gains and depreciation recapture, rolling the basis of the old property into the new one.

The transfer of assets through gifts or inheritances creates different tax outcomes. When an asset is given as a gift, the recipient generally assumes the donor’s adjusted basis, which is known as a “carryover basis.” When the recipient eventually sells the asset, they will calculate their capital gain using that original basis. In contrast, when an asset is inherited, the heir receives a “stepped-up basis,” where the basis is adjusted to its fair market value at the date of the original owner’s death. This often eliminates the capital gain for the heir if they sell the property shortly after inheriting it.

An installment sale offers another method for managing tax liability. This approach allows a seller to receive payments from a buyer over several years. Instead of recognizing the entire gain in the year of the sale, the seller reports a proportional amount of the gain in each year they receive a payment. A rule within installment sales relates to depreciation recapture. Unlike the capital gain, any gain attributable to depreciation recapture must be reported as income in the year the sale occurs, which can lead to a tax liability greater than the first installment payment.