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Depreciation Recapture When Selling a US Rental Property: The Extra Tax Owners Often Overlook

/ Blog (EN), Real Estate & Rental Income / By

After holding a U.S. rental property for many years and finally deciding to sell, many owners overlook something called depreciation recapture. The depreciation deductions that reduced your tax bill every year come back to bite you at sale time, as additional tax based on the cumulative amount you claimed. This article explains how recapture tax works on the sale of a rental property and how to think about the calculation.

Why Does Selling Trigger “Extra” Tax?

During ownership, the building portion of a rental property generates a depreciation deduction each year under MACRS (Modified Accelerated Cost Recovery System). That deduction reduces the property’s tax basis every year. Since capital gain at sale is calculated as sale price minus basis, the more depreciation you’ve claimed, the lower your basis — and the larger your gain at sale. In effect, the tax savings you enjoyed from depreciation during ownership get “recaptured” all at once when you sell.

“Unrecaptured Section 1250 Gain” and the 25% Cap

When an individual sells rental real estate (the building portion), the portion of the gain equal to the depreciation previously claimed is taxed as “Unrecaptured Section 1250 Gain” at a rate of up to 25%, separate from the ordinary long-term capital gains rates (0%, 15%, 20%). This is a more lenient rule specific to real estate (Section 1250 property), unlike the full recapture as ordinary income that applies to personal property such as equipment under Section 1245. Since only straight-line depreciation has been allowed on buildings since 1986, in practice most of the gain on selling a rental property falls into this “up to 25%” category.

How the Gain Breaks Down

Gain on selling a rental property is generally split into two categories for tax purposes:

  • Unrecaptured Section 1250 Gain: the portion of gain corresponding to depreciation you’ve claimed. Taxed at up to 25%.
  • Ordinary long-term capital gain: the portion of appreciation beyond the cumulative depreciation. Taxed at the standard long-term capital gains rates (0%, 15%, 20%).

For example, say you bought a property for $500,000, claimed $100,000 of depreciation during ownership, and sold it for $800,000. Your basis is now $400,000 ($500,000 minus $100,000), and your gain is $400,000 ($800,000 minus $400,000). Of that gain, $100,000 (equal to the cumulative depreciation) is Unrecaptured Section 1250 Gain taxed at up to 25%, and the remaining $300,000 is taxed at the ordinary long-term capital gains rates.

The “Allowed or Allowable” Trap: Taxed Even If You Never Claimed the Deduction

One especially important pitfall is the “allowed or allowable” rule. Even if you forgot to claim depreciation on your tax return for some reason, recapture is still calculated based on the depreciation you could have claimed. In other words, you can end up in the worst possible position: never having received the tax benefit, but still owing the extra tax at sale. If you discover missed depreciation in a prior return, Form 3115 (Application for Change in Accounting Method) offers a way to catch up retroactively, so it’s worth reviewing your filing history carefully before you sell.

An Added Layer for Nonresidents

If the seller is a Japanese resident, FIRPTA withholding (generally 15%) also applies at closing, separate from this gain calculation. Since that withholding is just an estimated amount based on the sale price, your actual final tax liability — combining the ordinary long-term gain and the Unrecaptured Section 1250 Gain — gets determined through your Form 1040NR filing, which reconciles the difference against what was withheld.

Frequently Asked Questions

Q: Does recapture tax apply if I sell at a loss?

A: No. Recapture only applies when there’s a gain. If you sell at a capital loss, the concept of Unrecaptured Section 1250 Gain simply doesn’t arise.

Q: Is there any way to avoid recapture tax?

A: It’s hard to avoid entirely, but a 1031 exchange lets you defer the tax due at sale (including the recapture portion) until you eventually sell the replacement property. As covered in our other article, that’s a deferral, not an exemption, and nonresidents also need to coordinate it with FIRPTA withholding.

This article is provided for general informational purposes only and is not a substitute for individualized tax advice. Depreciation history varies by property, so we recommend having a professional model your numbers before selling.

Summary

Selling a rental property means accounting not just for appreciation, but for the fact that the depreciation tax savings you enjoyed during ownership get taxed back at up to 25%. The “allowed or allowable” rule, which factors in depreciation you were entitled to claim even if you never did, is a commonly overlooked trap. As soon as you start considering a sale, review your depreciation history with a professional to get an accurate estimate of your tax exposure.

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