Selling a Rental Property: Depreciation Recapture, Unrecaptured Section 1250 Gain, and the Allowed or Allowable Trap

You bought a rental in Venice for $300,000. Ten years later you sell it for $450,000. Most owners think the gain is $150,000, taxed at capital gain rates. Then the preparer shows them a gain closer to $250,000, with a chunk of it taxed at a higher rate. What happened?

Depreciation happened. Every year you owned the property, depreciation lowered your taxable rental income. It also lowered your basis. The sale is where the IRS settles that account.

How depreciation lowers basis

Your adjusted basis starts with what you paid, plus closing costs and improvements. IRC 1016(a)(2) then reduces it for depreciation. The building portion of residential rental property is generally depreciated straight-line over 27.5 years. Land is never depreciated.

Using the example: if $240,000 of the $300,000 price was allocated to the building, annual depreciation is roughly $8,700. After ten years, about $87,000 of depreciation has been taken. Adjusted basis drops to roughly $213,000 before considering improvements and selling costs. Sell for $450,000, and the gain is about $237,000, not $150,000. These numbers are illustrations, but the structure is real.

The allowed or allowable rule

IRC 1016(a)(2) reduces basis by depreciation allowed, but not less than the amount allowable. That phrase is a trap. If you did not claim depreciation, the IRS still reduces your basis by what you could have claimed. You get the higher gain at sale without ever having taken the deductions.

This is common with owners who prepared their own returns or who converted a former residence into a rental and forgot to start depreciating it. The fix is a change in accounting method on Form 3115, which can let you claim the missed depreciation in a single year, sometimes even the year of sale. See the Form 3115 guide before you file the sale year return.

Three layers of gain

The gain on a rental sale is split into layers, each taxed differently.

Layer one: section 1245 recapture on personal property

Appliances, carpet, furniture, and certain land improvements depreciated over shorter lives are section 1245 property. Under IRC 1245, gain on that property is ordinary income to the extent of depreciation taken. If you allocated part of the sale price to these items, that allocation matters. If you did not track them separately, the gain usually rides with the building.

Layer two: unrecaptured section 1250 gain

Buildings are section 1250 property. IRC 1250 requires ordinary income recapture only for depreciation in excess of straight-line. Residential rental property placed in service after 1986 is depreciated straight-line, so for most landlords there is little or no IRC 1250 ordinary recapture.

The depreciation still comes back, though, through the rate rules. IRC 1(h)(6) defines unrecaptured section 1250 gain as the long-term capital gain attributable to depreciation on section 1250 property that is not otherwise treated as ordinary income. IRC 1(h)(1)(E) taxes it at a maximum rate of 25 percent. That is the layer most owners do not see coming.

Layer three: remaining capital gain

Whatever gain is left above the depreciation layers is generally long-term capital gain, taxed at the usual capital gain rates, if you held the property more than one year. Real property used in a trade or business can be section 1231 property, and section 1231 netting with other gains and losses happens on Form 4797.

Net investment income tax

IRC 1411 imposes a 3.8 percent tax on net investment income for individuals whose modified adjusted gross income exceeds a threshold: $250,000 for married filing jointly, $200,000 for single filers, and $125,000 for married filing separately. Those thresholds are set in the statute and are not indexed for inflation. Gain on the sale of a rental is generally net investment income unless the rental rises to a nonpassive trade or business. A large sale can push income over the threshold in the year of sale even if you are normally below it.

Suspended passive losses come off the shelf

If your rental produced losses you could not deduct because of the passive activity rules, those losses have been carrying forward. IRC 469(g) generally allows them in full when you dispose of your entire interest in the activity in a fully taxable transaction to an unrelated party. They offset the gain, and any excess offsets other income. See the passive loss allowance guide for how they accumulate.

Selling to a relative, or exchanging under IRC 1031, does not trigger this release in the same way. Know the effect before you choose the buyer or the structure.

Installment sales and recapture

Seller financing spreads gain over the years you receive payments under IRC 453. Recapture income is the exception. IRC 453(i) requires recapture income, meaning amounts treated as ordinary income under IRC 1245 or 1250, to be recognized in the year of sale, regardless of when you are paid. For most residential rentals that is mainly the section 1245 personal property piece. Unrecaptured section 1250 gain is not recapture income for this purpose and is reported as payments come in, with special ordering rules.

Reporting the sale

The sale of rental property is generally reported on Form 4797, Sales of Business Property, with the results flowing to Schedule D. The unrecaptured section 1250 gain worksheet in the Schedule D instructions computes the 25 percent layer. Publication 544 explains sales and other dispositions of assets in detail, and Publication 527 covers rental property.

Gather before you file:

• The purchase closing statement and the original land and building allocation
• Every year's depreciation schedule, including improvements and their placed-in-service dates
• The sale closing statement
• Records of suspended passive losses from prior Forms 8582
• Any Form 1099-S issued for the sale

Audit issues on rental sales

Examiners look at four things on rental dispositions. First, whether the reported basis is supported by records. Second, whether depreciation was taken, and if not, whether basis was still reduced. Third, whether improvements claimed as basis additions were real and documented. Fourth, whether the sale was correctly split between land, building, and personal property. Repairs versus improvements decisions made years earlier come back here too; see the repairs versus improvements guide.

If you are considering deferring all of this through a like-kind exchange, read the 1031 deadline guide first. The deadlines are strict.

Depreciation is a loan from the Treasury. The sale is the due date.