Updated · Part of the CRE investment glossary
How depreciation recapture works
Depreciation lowers your adjusted basis every year you own a property. When you sell, gain is measured against that lower basis, so each dollar of depreciation becomes a dollar of gain, up to the total gain. The tax code then decides what rate that part of the gain pays.
Basis is reduced by depreciation "allowed or allowable" — the amount you could have claimed, even if you did not claim it (IRS Publication 544). Skipping depreciation does not avoid recapture; it only loses the deduction.
Section 1250 vs unrecaptured section 1250 gain
Section 1250 covers depreciable real property: buildings and their structural components. It recaptures as ordinary income only "additional depreciation", meaning depreciation above straight line. Buildings placed in service after 1986 are depreciated on a straight line under MACRS, so there is generally no additional depreciation and no ordinary §1250 recapture (Publication 544).
What remains is unrecaptured section 1250 gain, defined in Internal Revenue Code §1(h)(6): the long-term gain that comes from straight-line depreciation on the building. It is taxed at the seller’s ordinary rate, capped at 25% (IRS Topic 409). Gain above it is long-term capital gain at 0%, 15% or 20%. Net investment income tax and state tax can apply on top — ask your CPA.
The formula
For a building held more than a year and depreciated on a straight line:
Unrecaptured §1250 gain = lesser of (total gain) and (depreciation allowed or allowable)
- Total gain: amount realized on the sale minus adjusted basis.
- Adjusted basis: cost plus improvements minus depreciation allowed or allowable.
- Remaining gain: total gain minus unrecaptured §1250 gain, taxed as long-term capital gain.
Worked example: a sale after five and a half years
An investor buys a rental building for $10,000,000: $2,000,000 for land and $8,000,000 for the building, depreciated over 27.5 years. After 5.5 years the depreciation taken is $8,000,000 ÷ 27.5 × 5.5 = $1,600,000. The property sells for $12,000,000 net of selling costs. Rates shown are the federal maximums; the investor’s actual rate may be lower.
The investor deducted $1,600,000 while holding and pays up to 25% on the same amount at sale. Whether that trade was favourable depends on the rate at which the deductions were used, and when.
| Line | Arithmetic | Amount |
|---|---|---|
| Adjusted basis | $10,000,000 − $1,600,000 | $8,400,000 |
| Total gain | $12,000,000 − $8,400,000 | $3,600,000 |
| Unrecaptured §1250 gain | Lesser of $3,600,000 and $1,600,000 | $1,600,000 |
| Tax on it, at most 25% | 25% × $1,600,000 | $400,000 |
| Long-term capital gain | $3,600,000 − $1,600,000 | $2,000,000 |
| Tax on it, at most 20% | 20% × $2,000,000 | $400,000 |
Cost segregation, 1031 exchanges and syndications
Three situations change the picture:
- Cost segregation: 5- and 7-year personal property is §1245 property. Gain on it, up to the depreciation taken, is ordinary income and not capped at 25%. The sale price has to be allocated between the building and those components.
- 1031 exchange: exchanging into like-kind real property defers the gain, including the depreciation part, into the replacement property’s basis. Publication 544 notes that ordinary-income recapture can still arise in some exchanges.
- Syndications: the partnership sells the property and reports each partner’s share of unrecaptured §1250 gain on Schedule K-1 (Form 1065), box 9c. Investors see it in the year of the sale.
Primary sources
General information, not legal, tax or investment advice. Your operating agreement, offering documents, counsel and CPA govern your deal.