How Depreciation Works on Rental Property

When you buy rental property, you can’t deduct the entire purchase price in year one. Instead, the IRS makes you spread the cost of the building (not the land) over its useful life under IRC Section 168. For residential rental property, that’s 27.5 years. For commercial property, it’s 39 years. The IRS explains the basics in Publication 946, How to Depreciate Property.

Say you buy a residential rental for $500,000. The land is worth $100,000 and the building is worth $400,000. Each year, you deduct $400,000 / 27.5 = $14,545 in depreciation. That reduces your rental income on paper, which lowers your tax bill.

After 10 years of ownership, you’ve claimed about $145,450 in depreciation deductions. Your adjusted basis in the property has dropped from $500,000 to $354,550. That lower basis is what creates the recapture problem when you sell.

What Depreciation Recapture Actually Is

Depreciation recapture is the IRS’s way of clawing back the tax benefit you received from those annual depreciation deductions. The logic is straightforward: if the property didn’t actually lose value (and most real estate appreciates), then those deductions were a temporary benefit, not a permanent one.

When you sell, the gain attributable to the depreciation you took gets taxed at a special rate — up to 25%. That’s the unrecaptured Section 1250 gain rate. It’s higher than the 15% or 20% long-term capital gains rate most people expect to pay. The IRS covers the reporting requirements in Publication 544, Sales and Other Dispositions of Assets.

Using our example: you bought for $500,000, claimed $145,450 in depreciation, and your adjusted basis is now $354,550. If you sell for $600,000, your total gain is $245,450. Of that gain, $145,450 is depreciation recapture (taxed at up to 25%), and the remaining $100,000 is regular capital gain (taxed at 15% or 20%).

The Math Behind the Tax Bill

Let’s walk through a full calculation for someone in the 24% federal income tax bracket selling that $600,000 property:

• Sale price: $600,000
• Original cost basis: $500,000
• Accumulated depreciation (10 years): $145,450
• Adjusted basis: $354,550
• Total gain: $245,450
• Depreciation recapture portion: $145,450 taxed at 25% = $36,363
• Capital gain portion: $100,000 taxed at 15% = $15,000
• Total federal tax on sale: approximately $51,363

That’s before state taxes and before the net investment income tax. A lot of sellers are shocked by this number because they only planned for the capital gains tax and forgot about recapture entirely.

You Owe Recapture Even If You Didn’t Take the Deductions

This surprises almost everyone. The IRS calculates depreciation recapture based on the depreciation you should have taken, not just what you actually claimed. If you owned a rental property for 10 years and never deducted depreciation — maybe you didn’t know you could, or your accountant missed it — the IRS still taxes you on the depreciation you were entitled to.

The tax code says your basis is reduced by the depreciation “allowed or allowable” under IRC Section 1016(a)(2). Allowable means you could have taken it. So skipping the deduction doesn’t save you from recapture. It just means you lost the annual tax benefit and still owe the recapture tax. That’s the worst possible outcome.

If you’ve been holding rental property without claiming depreciation, talk to your CPA about filing amended returns to pick up those missed deductions. The IRS allows you to correct depreciation errors going back to the year the property was placed in service using Form 3115 (change of accounting method). Don’t leave money on the table twice.

How Capital Gains and Recapture Interact

The total gain on a rental property sale gets split into two buckets, as described in the Schedule D instructions:

• Unrecaptured Section 1250 gain — the portion equal to your accumulated depreciation. Taxed at a maximum rate of 25%. If your ordinary income tax rate is below 25%, you pay at your ordinary rate instead.
• Long-term capital gain — everything above the recapture amount. Taxed at 0%, 15%, or 20% depending on your income under IRC Section 1(h).

Both buckets are also subject to the 3.8% net investment income tax (NIIT) under IRC Section 1411 if your modified adjusted gross income exceeds $200,000 (single) or $250,000 (married filing jointly). That pushes the effective rate on depreciation recapture to 28.8% and capital gains to 23.8% for higher-income sellers.

For a deep look at the NIIT and how it applies to real estate sales, see our capital gains tax calculator for property sales.

Deferring Recapture with a 1031 Exchange

A Section 1031 exchange under IRC Section 1031 lets you sell one investment property and buy another of equal or greater value without recognizing gain — including depreciation recapture. The tax isn’t eliminated; it’s deferred to the replacement property. Your basis in the new property carries over the deferred gain.

The rules are strict. You have 45 days to identify a replacement property and 180 days to close. The replacement must be “like-kind” (real property for real property — residential for commercial is fine). You need a qualified intermediary to hold the sale proceeds; you can’t touch the money yourself. The IRS outlines the requirements in Publication 544 and the Form 8824 instructions.

Investors who do serial 1031 exchanges can defer recapture indefinitely. And if the final property is held until death, the heirs receive a stepped-up basis under IRC Section 1014, potentially eliminating the deferred gain entirely. That’s one of the most powerful long-term strategies in real estate tax planning.

Installment Sales: Spreading the Pain

An installment sale under IRC Section 453 lets you receive the sale proceeds over multiple years, which spreads the gain (and the tax) across those years. This can keep you in a lower bracket and reduce or avoid the NIIT surcharge. The IRS covers the mechanics in Publication 537, Installment Sales.

There’s a catch with depreciation recapture, though: under IRC Section 453(i), depreciation recapture is recognized in full in the year of sale, even if you’re receiving payments over time. Only the capital gain portion can be spread. So an installment sale helps with the capital gains piece but doesn’t defer the recapture portion.

That said, if the capital gain is significantly larger than the recapture, an installment sale can still save you a meaningful amount. Run the numbers with your CPA before committing to the structure.

Other Strategies to Manage the Tax Hit

Opportunity Zone Investment

If you reinvest capital gains from a property sale into a Qualified Opportunity Zone fund within 180 days under IRC Section 1400Z-2, you can defer the capital gains portion. The depreciation recapture is still owed, but deferring the capital gain reduces the immediate tax bill.

Charitable Remainder Trust

Contributing a property to a charitable remainder trust (CRT) before selling can spread the gain over the trust’s payout period. The CRT sells the property tax-free, and you receive distributions over time. You also get a charitable deduction. This works best for people who want to support a charity and don’t need the full sale proceeds immediately.

Cost Segregation Studies

A cost segregation study reclassifies components of a building (carpeting, appliances, certain fixtures) into shorter depreciation schedules (5, 7, or 15 years instead of 27.5 or 39). This accelerates depreciation deductions during ownership. But be aware: those accelerated deductions increase the recapture amount at sale. Cost segregation is most valuable if you plan to hold long-term or do a 1031 exchange when you sell. For more on how capital gains work in states without income tax, see our Florida capital gains guide.

Sources & References

• 26 U.S.C. § 1250 — Gain from Dispositions of Certain Depreciable Realty
• 26 U.S.C. § 168 — Accelerated Cost Recovery System (MACRS)
• 26 U.S.C. § 1016 — Adjustments to Basis
• 26 U.S.C. § 1031 — Exchange of Real Property Held for Productive Use or Investment
• 26 U.S.C. § 453 — Installment Method
• 26 U.S.C. § 1411 — Imposition of Net Investment Income Tax
• 26 U.S.C. § 1014 — Basis of Property Acquired from a Decedent
• 26 U.S.C. § 1400Z-2 — Special Rules for Capital Gains Invested in Opportunity Zones
• IRS Publication 946 — How to Depreciate Property
• IRS Publication 544 — Sales and Other Dispositions of Assets
• IRS Publication 537 — Installment Sales
• IRS — About Form 3115, Application for Change in Accounting Method
• IRS — About Form 8824, Like-Kind Exchanges