Depreciation Recapture: Why Your Gain at Sale Isn't All Capital Gain

Depreciation is a timing benefit, and the exit is when the timing ends

Every year you own a short-term rental, depreciation reduces your taxable income. When those deductions are currently usable, they offset income otherwise taxed at ordinary rates — the highest rate you pay — and that is genuinely valuable. Whether a given year's deduction is usable now is its own question, since passive-activity and other limitations can suspend it to a later year. What depreciation does not do, in either case, is make the money tax-free. It moves the tax.

The mechanism is easier to see through basis. Each dollar of depreciation reduces adjusted basis (§1016(a)(2)), and gain is amount realized minus adjusted basis (§1001(a)). So a dollar deducted during the hold is a dollar of extra gain waiting at the exit — automatically, arithmetically, whether or not anyone planned for it. Depreciation does not reduce your lifetime tax on the property so much as it reschedules it: a deduction now, a larger gain later.

Recapture is the second half of that bargain. Left alone, the mechanism above would let you take deductions against ordinary income and then settle up at long-term capital gain rates — converting the character of income, not just its timing. The recapture rules exist to stop that conversion. They ask a specific question at disposition: how much of this gain is just the depreciation coming back? And they tax that portion differently from the rest.

This is educational information about how the recapture rules work, not individualized tax advice. How they apply turns on your depreciation schedule, your asset classes and your actual disposition, and should be confirmed with your own qualified tax professional. Where something below is our read rather than black-letter rule, it is labelled.

One property, two regimes

The first thing to understand is that recapture is not one rule applied to one number. Your property is a collection of assets, each sitting in one of two statutory regimes, and the regimes behave very differently.

§1245 property is, broadly, depreciable personal property — appliances, furniture, carpeting, cabinetry, specialty electrical and plumbing, equipment. In a short-term rental this category is large, and a cost segregation study makes it larger on purpose.

§1250 property is depreciable real property that is not §1245 property — principally the building itself.

Land is in neither, because land is not depreciated. There is no recapture on the land allocation; gain attributable to land is simply capital gain.

This is the same split the basis page describes as "several ledgers rather than one," and here is where that structure earns its keep. Adjusted basis tells you how much gain there is. The regime each ledger sits in tells you what kind of gain it is — and the difference between the two answers can be many percentage points of tax.

§1245: the fast components come back as ordinary income

For §1245 property, the rule is blunt. On a sale at a gain, the gain is treated as ordinary income to the extent of all depreciation allowed or allowable on that asset (§1245(a)). Not the excess over straight-line. Not a portion. All of it, up to the amount of gain — and, as with basis, the test is what was allowable, not merely what was claimed.

Three features of that rule matter for a short-term-rental owner.

It is taxed at ordinary rates. There is no preferential rate for §1245 recapture and no 25 percent ceiling — it is stacked with your other ordinary income and taxed accordingly. Owners who have heard "recapture is 25 percent" have heard something about a different regime, and applying that number here will understate the bill.

It counts accelerated depreciation in full. Bonus depreciation under §168(k) and expensing under §179 are still depreciation for this purpose. An asset written off entirely in year one has been depreciated to zero, so essentially the whole of any gain on it is ordinary. The faster the write-off, the more complete the recapture.

And it applies asset by asset, not to the property as a whole. Each item on the depreciation schedule carries its own recapture calculation. This is why the schedule matters so much and why a schedule that was never maintained is a real problem at closing rather than an administrative one.

There is a related rule worth knowing even though it fires before any sale: if business use of §179 property drops to 50 percent or less, part of the expensing is recaptured in that year (§179(d)(10)). An STR that converts to substantial personal use is the obvious way an owner meets that rule without selling anything.

§1250: the building comes back too — at its own rate

Here is the part that surprises people who thought they had avoided the problem by depreciating the building slowly.

Real property placed in service after 1986 is depreciated straight-line, so there is generally no "additional depreciation" — no excess over straight-line — and therefore generally little or no §1250 ordinary recapture on the building. That much is good news, and it is where most explanations stop.

But a separate rule picks it up. The portion of your long-term capital gain attributable to prior straight-line depreciation on real property is unrecaptured §1250 gain, and under current law it is taxed at your ordinary rate subject to a 25 percent ceiling (§1(h)). Read the ceiling as a maximum rather than a flat rate: 25 percent is the most it can be taxed at, not automatically what every dollar of it costs. It is still capital gain — it is not ordinary income, and it is not §1245 recapture — but it does not receive the 15 or 20 percent rate that applies to the rest of your long-term capital gain.

So the honest statement is that depreciation on the building comes back as well. It comes back in a gentler form and at a capped rate, but there is no version of straight-line depreciation that leaves nothing behind at the exit. Depreciating slowly changes the rate at which the building's depreciation returns. It does not stop it returning.

Land improvements: the piece that behaves like neither

Between the two sits a category most STR owners have and few think about: land improvements — driveways, fencing, pools, decking, landscaping, exterior lighting. A cost segregation study typically assigns these a 15-year recovery period.

These are generally §1250 property rather than §1245, so the ordinary-recapture rule above does not simply apply to them. But unlike the building, they are depreciated on an accelerated method rather than straight-line, and they are frequently eligible for bonus depreciation. That means, unlike the building, they can carry additional depreciation — depreciation in excess of what straight-line would have produced — which is precisely what §1250 ordinary recapture reaches.

We are flagging this rather than resolving it, deliberately. How much of a given owner's land-improvement depreciation is additional depreciation, and how it characterises on their particular disposition, depends on the method actually used, the bonus percentage in the placed-in-service year and the facts of the sale. It is a genuine question for your tax professional and one of the more common places a self-computed estimate goes wrong. What you should take from this page is that the pool and the driveway do not automatically follow the building's treatment.

Recapture cannot exceed gain — but "gain" is measured asset by asset

The mechanism has one important limit, and it is the only real relief in it. It is also the limit most often misread, because the natural instinct is to apply it to the property.

Recapture applies only to gain. §1245 recharacterizes gain as ordinary; it does not create income where there is none. An individual depreciated asset sold at a loss produces no recapture on that asset, because there is no gain for §1245 to reach. Unrecaptured §1250 gain works the same way — it is a slice of capital gain, and if there is no capital gain there is no slice.

Now apply that to a short-term rental, which is not one asset but a collection of them. A sale of the property is a multi-asset disposition: the consideration is allocated among the assets, and gain or loss is computed separately for each. So an overall loss on the property does not necessarily mean zero recapture. Individual §1245 components — the furnishings and short-life assets a cost segregation study wrote down toward zero — can still be allocated proceeds that exceed their adjusted basis, and each of those produces ordinary recapture on its own, whatever the transaction did economically.

That is the same asset-ledger structure this page opened with, showing up where it matters most. "I did not really make anything on this sale" is a property-level, economic statement. The recapture calculation is neither: it runs down the depreciation schedule, asset by asset, against an allocation of the price. A property that sells for roughly what you paid for it has still generated substantial taxable gain on individual ledgers, because their basis fell every year you held it.

Once recapture has taken its portion, what remains on business property held more than a year is generally §1231 gain, which is treated as long-term capital gain. That treatment carries its own wrinkle: §1231(c) looks back five years, and net §1231 losses claimed as ordinary in that window recharacterize a corresponding amount of this year's gain as ordinary. Depending on your income, the 3.8 percent net investment income tax under §1411 may sit on top of the capital-gain pieces as well. This page is about character; the assembled bill, with rates and stacking, is the exit-tax page's job.

What a cost segregation study actually traded

It should now be clear what a cost segregation study does at both ends of the hold, and it is worth stating plainly because the sales pitch usually covers only one end.

A study moves basis out of the 27.5-year building and into 5-, 7- and 15-year classes. During the hold, that accelerates deductions against ordinary income — a real benefit, and often a large one, especially where the owner can use those losses currently. At the exit, the same reallocation means a larger share of your gain sits in §1245 ledgers that recapture as ordinary income, rather than in the building's ledger, which returns as capital gain under a 25 percent ceiling.

So the trade is a timing-and-rate trade: deductions now at ordinary rates, against a portion of the gain later at ordinary rates. Whether that comes out ahead turns on the time value of the deferral, whether the deductions were usable when taken, the owner's rates in both periods, and how the property is eventually disposed of. For many operators it still does come out ahead. Our point is not that cost segregation is a bad idea — it is that the exit consequence is part of the calculation and is routinely left out of it. An owner who models the study's benefit without modelling the recapture is comparing half of one thing to none of another.

Where recapture follows you

Recapture attaches to the property's depreciation history, so it travels with the property through most of the exits an owner considers.

A 1031 exchange defers it. Roll into a replacement property and the gain — recapture included — is generally deferred rather than eliminated, carried forward in the reduced basis you take in the new property. There is an important limitation for cost-segregated owners: since 2018, §1031 applies only to real property. Components that a study classified as personal property are generally not eligible for like-kind exchange treatment, so gain attributable to them, including ordinary §1245 recapture, can be recognized even inside an otherwise successful exchange. Whether a particular component is real property for §1031 purposes is a technical determination and exactly the kind of thing to settle with your advisor before the exchange, not after.

An installment sale does not spread it. Under §453(i) the ordinary depreciation-recapture income is generally recognized in the year of sale regardless of when you are paid, which can produce a real year-one tax bill while most of the price is still outstanding. The installment guide covers that in full.

Death ends it. Under current law, a basis step-up at death under §1014 resets basis to date-of-death value for the heir, and the built-in gain — recapture included — that accumulated during the owner's life is not taxed to them. That is the one exit where the accumulated liability disappears rather than moving, and it is a consequence of holding, not a strategy anyone executes.

It is computed from the schedule, not estimated from the price

Everything above is a computation over your depreciation schedule, asset by asset, and the quality of that schedule decides whether the number you get is right.

That means the schedule needs to be accurate and current: each asset class carried separately, the cost segregation study retained with its allocations, bonus and §179 elections recorded, and components that were replaced actually removed from the schedule rather than left on it. That last one is worth its own sentence. When you replace a roof or an HVAC system, a partial-asset-disposition election lets you write off the remaining basis of the component you removed — and, just as importantly, take it off the schedule so it is not still sitting there generating recapture on an asset that no longer exists.

The owner with a clean schedule can model an exchange against real numbers, decide between selling and refinancing on facts, and see the year-one number before agreeing to installment terms. The owner without one finds out what the character split was after the return is filed.