I bought my first home in 2013.
I sold it in 2019 for about double what I paid.
But it was too early.
Prices jumped after that. What I took from it is that the plan matters more than the property.
That home was a place to live and not a rental. The tax part of this guide did not apply to it. The lesson did. The exit is not the last step. It is a decision you make at the start.
A rental property has an exit too and the exit has a tax part. When people look up rental property and depreciation recapture together this is the part they mean. This guide explains it in plain words. It is education, not tax advice. Your CPA makes the call on your return.
What is depreciation recapture?
Each year the tax code lets you deduct a slice of a rental building's cost. That slice is depreciation. Land is not included because land does not wear out (IRS Publication 527).
Every slice you deduct lowers your tax basis in the property. Basis is your investment in the property for tax purposes (IRS Publication 551).
When you sell the gain is the sale price minus that lowered basis. So the gain is bigger by the amount of depreciation you took. Recapture is the name for how the tax code treats that slice of the gain. It treats it differently from the rest (IRS Publication 544).
Depreciation made your tax picture lighter along the way. Recapture is the part that shows up at the exit. Both come from the same deduction.
What is unrecaptured section 1250 gain?
This is the phrase that stops people. Here it is in plain words.
Section 1250 is the part of the tax code that covers real property like a building. Unrecaptured section 1250 gain is the part of your gain on the sale that comes from the depreciation you took on that building. It cannot be more than your total gain on the sale (IRS Publication 544).
Your CPA figures it on a worksheet in the instructions for Schedule D and reports the sale on Form 4797 (Instructions for Schedule D and Instructions for Form 4797). The tax code gives this slice its own treatment. What applies depends on your income and the year you sell. If you qualify; your CPA decides.
Is there a second kind of recapture?
Yes. The parts of a rental with shorter tax lives are treated under a different section. Think of flooring and fixtures and appliances that a cost segregation study moves into 5-year or 7-year property. When you sell the gain on those parts up to the depreciation taken is generally treated as ordinary income (IRS Publication 544).
That is not a reason to skip a study. It is a reason to know the exit before you order one. Our guide to cost segregation explains when a study is worth ordering and what to ask first. The total deduction over the life of the property does not change. The timing does. The same goes for recapture.
A worked illustration
This is an illustration with round invented numbers. It is not a forecast and not your situation. It ignores selling costs and improvements and state tax. It uses straight-line depreciation over 27.5 years with the building placed in service in July.
- You buy a rental for 350,000. Your CPA allocates 275,000 to the building and 75,000 to the land.
- Depreciation on the building is 10,000 for a full year. The first year is partial and comes to 4,583.
- After ten years you have taken 94,583 of depreciation. Your adjusted basis is 350,000 minus 94,583 or 255,417.
- You sell at the end of year ten for 450,000. Your gain is 450,000 minus 255,417 or 194,583.
- Of that gain 94,583 is the part due to depreciation. That is the amount the unrecaptured section 1250 idea is about.
- The other 100,000 is the gain from the property being worth more than you paid. It is treated under the usual long-term gain rules.
The example shows one thing. The depreciation you took in the years you owned the property does not disappear at sale. It comes back as a part of the gain. How each part is taxed is your CPA's call.
Two more facts from the IRS worth knowing. Depreciation counts as taken whether you claimed it or not. The tax code looks at the amount "allowed or allowable" (IRS Publication 544). And if you sell for a loss there is no gain to split.
Why does the exit plan start on day one?
Because the choices that shape the exit are made at the start.
- How you hold it. A short-term rental and a long-term rental can depreciate differently. A study changes how much sits in the shorter-life bucket.
- The records. The depreciation schedule you keep from year one is the record your CPA uses at sale. A missing schedule is a missing answer.
- Suspended losses. Rental losses you could not use along the way are carried forward. They are generally released when you sell your entire interest in a fully taxable sale to someone unrelated. Our guide to the $25,000 rental loss rule explains why so many high earners have them.
- Which exit. Every property ends one of three ways. You sell it. You keep it for income. You pass it on. Each has a different tax result and your CPA and your attorney decide how.
Write four exit questions on day one.
- How long do I expect to hold this property?
- Which exit do I expect and what would change my mind?
- Who will keep the depreciation records and where do they live?
- What would I want my CPA to model before I buy and not after?
Why this matters to a CPA
If you prepare returns for W-2 households you already know this conversation happens late. The sale is on the calendar before anyone asks about recapture. A one-page list of exit questions given to a client at purchase moves it earlier. Our page for professionals who work with our clients explains how the program fits next to your work.
Questions to bring to your CPA
- If we sold in 5 years or in 10 how would the gain split between the part due to depreciation and the rest?
- Does anything we plan to do now such as a study change that split?
- Do we have suspended losses and what happens to them when we sell?
- What happens to the depreciation history if the property passes to our heirs instead of being sold?
- Which of our records will you need at sale and who keeps them?
Our checklist for your CPA meeting has an exit section you can fill in before that conversation. If you want to see where your household stands first take the Full Blueprint Check. It never recommends buying and deciding not to buy is a good outcome.
How The Full Blueprint fits in
The Full Blueprint is one-on-one coaching that walks a household through this in order: the goal and the professionals and the property and the numbers and the records and the exit. The exit plan is set while it can still change. We introduce you to CPAs and estate attorneys and cost segregation specialists. You choose who you work with and your CPA makes the tax calls. The Full Blueprint is a coaching program of Twenty-Five Media Group LLC. It is separate from any lender and never arranges financing.
See your numbers: a free estimate built from your own inputs. It shows what may be possible if you qualify.
Get the Right Hand Letter: short letters on ownership and taxes and planning for high earners. Get the Right Hand Letter
Book a 15-minute Blueprint call to walk through your own situation: pick a time