Can a Capital Loss Offset Depreciation Recapture?

Two types of recapture, two different answers

Depreciation recapture comes in two flavors. Unrecaptured Section 1250 gain — the kind most rental property sellers face — is technically a capital gain, taxed at a maximum federal rate of 25%. Because it is capital gain, capital losses can offset it. If you have $30,000 of capital losses from selling stocks and $30,000 of unrecaptured Section 1250 gain, the losses wipe out the gain entirely.

Section 1245 recapture is different. It is taxed as ordinary income — the same rate as wages. Capital losses cannot offset ordinary income. If you accelerated depreciation through a cost segregation study, the recapture on those short-life personal property components is 1245 ordinary income and cannot be sheltered by capital losses.

How the netting works in practice

When you sell a rental property, your total gain is divided into three slices: (1) Section 1245 recapture taxed as ordinary income, (2) unrecaptured Section 1250 gain taxed at up to 25%, and (3) any remaining long-term capital gain taxed at 0/15/20%. Capital losses you have (from stocks, for example) are first applied against long-term capital gains, then against any remaining unrecaptured Section 1250 gain in the same year.

Example: You sell a rental and have $20,000 of unrecaptured Section 1250 gain and $40,000 of long-term capital gain. You also have $50,000 in capital losses from a stock portfolio. The capital losses wipe out all $40,000 of long-term gain and $10,000 of the Section 1250 gain. You owe tax on only $10,000 of unrecaptured Section 1250 gain. The losses do nothing to offset any Section 1245 ordinary recapture.

Why this matters for cost segregation planning

A cost segregation study accelerates depreciation by reclassifying building components as short-life personal property. Those components produce Section 1245 recapture when you sell — recapture that capital losses cannot shelter. The long-term capital gain slice and the unrecaptured Section 1250 slice can both be offset by capital losses, but the 1245 slice cannot.

If you are planning a sale and hold capital losses, run the numbers before assuming those losses fully shelter your recapture tax. Coordinate with a tax professional to model the exact split among the three gain categories for your property.

A full three-slice worked example

Suppose you bought a rental for $400,000 (excluding land), later ran a cost segregation study, and over the years claimed $150,000 of total depreciation — $40,000 of it on 5- and 7-year personal property and $110,000 on the building. Your adjusted basis is now $250,000. You sell for $520,000 with $20,000 of selling costs, for an amount realized of $500,000 and a total gain of $250,000.

That $250,000 gain splits into three slices. The Section 1245 recapture equals the $40,000 of personal-property depreciation, taxed as ordinary income. The unrecaptured Section 1250 gain equals the $110,000 of building depreciation, taxed at up to 25%. The remaining $100,000 is long-term capital gain taxed at 0/15/20%.

Now suppose you also have $130,000 of capital losses from selling stocks. Capital losses apply first to long-term capital gain, then to unrecaptured Section 1250 gain: the $130,000 wipes out the entire $100,000 long-term slice and $30,000 of the $110,000 Section 1250 slice. You are left owing tax on $80,000 of unrecaptured Section 1250 gain (up to 25%) and the full $40,000 of Section 1245 recapture as ordinary income. The capital losses never reduce the 1245 ordinary slice — that is the key limitation.

Section 1231 netting and the five-year lookback

Most depreciable rental property is Section 1231 property. In a year you sell, you net all of your Section 1231 gains and losses. A net Section 1231 gain is treated as long-term capital gain (eligible for capital-loss offset and preferential rates); a net Section 1231 loss is treated as an ordinary loss (fully deductible against ordinary income). This asymmetry is one of the most favorable rules in the code.

But watch the five-year lookback rule of Section 1231(c): a net Section 1231 gain is recharacterized as ordinary income to the extent you deducted net Section 1231 losses in the prior five years. If you took a $30,000 ordinary 1231 loss two years ago and now have a $30,000 net 1231 gain, that gain is ordinary — and capital losses cannot offset ordinary income. Check your prior five years before assuming your gain is capital.

The $3,000 limit and carryforwards

If your capital losses exceed both your capital gains and your unrecaptured Section 1250 gain for the year, you can deduct only up to $3,000 of the net excess against ordinary income ($1,500 if married filing separately). The rest carries forward indefinitely under Section 1212, keeping its character. So a large capital loss cannot be used all at once to shelter a big recapture year unless you have enough capital gain and Section 1250 gain in that same year to absorb it.

Don't forget the 3.8% Net Investment Income Tax

Both the capital-gain slice and the unrecaptured Section 1250 gain from selling a rental are generally net investment income, so the 3.8% NIIT can apply on top of the regular tax if your modified AGI exceeds $200,000 (single) or $250,000 (married filing jointly). Capital losses that reduce your net gain also reduce the NIIT base. Section 1245 ordinary recapture is generally not investment income for NIIT if the property was used in a non-passive trade or business, but is included for passive investors — another reason the character of each slice matters.

Freeing suspended passive losses in the same sale

If the rental generated suspended passive losses you could not previously deduct, a fully taxable sale to an unrelated party releases them under Section 469(g). Those freed losses are ordinary and can offset the Section 1245 recapture as well as any other income — reaching the very slice that capital losses cannot. So while capital losses shelter the 1250 and capital slices, suspended passive losses can shelter the ordinary 1245 slice. Coordinating both in the sale year can dramatically cut the total tax.

Planning: bunch losses into the sale year

Because capital losses offset the 1250 and capital slices dollar-for-dollar with no $3,000 ceiling when gains are present, the sale year is the ideal time to harvest other capital losses — selling underwater securities or other property to generate losses that soak up the gain. Run the full three-slice split first so you know how much loss you actually need and which slices it can and cannot reach.

Ordinary recapture cannot be sheltered by capital losses — a summary

To make the rule concrete: capital losses can offset the long-term capital gain slice and the unrecaptured Section 1250 slice, both of which are capital in nature. They can never offset the Section 1245 ordinary recapture slice, which is taxed like wages. If your sale is dominated by 1245 recapture — common after an aggressive cost segregation study on a property held only a few years — capital losses will do less for you than you might hope. In that situation, look to ordinary offsets instead: suspended passive losses freed at sale, current-year rental losses, or non-passive business losses.

This is also a reason to be thoughtful about how aggressively you accelerate depreciation if you expect to sell before the time value clearly favors it. The more depreciation you push into short-life 1245 property, the more of your eventual gain becomes ordinary recapture that capital losses cannot touch.

Timing the sale across tax years

Because the $3,000 ceiling only bites when you lack gains to absorb losses, and because the five-year Section 1231 lookback can turn a capital gain ordinary, timing matters. If you are carrying large capital losses, selling an appreciated rental in a year when those losses are still available lets them offset the 1250 and capital slices in full. Conversely, if you took ordinary 1231 losses in the last five years, consider whether deferring the sale past the lookback window preserves capital-gain treatment. A short conversation with your CPA before listing the property can change the after-tax result by tens of thousands of dollars.

A note on carryover basis and inherited losses

If you inherit a rental, your basis is generally stepped up to fair market value at the decedent's death, wiping out the built-in gain and the depreciation recapture that would otherwise have applied — so there is nothing for capital losses to offset. But the decedent's unused capital-loss carryforwards do not pass to you; they are lost. Coordinate estate and sale planning so valuable carryforwards are used during life and the step-up is captured at death.

Frequently asked questions

Do capital losses offset unrecaptured Section 1250 gain before or after regular capital gain?

After. Capital losses apply first to your net capital gains, and only the remainder offsets unrecaptured Section 1250 gain in the same year.

Can suspended passive losses offset Section 1245 recapture?

Yes. Suspended passive losses freed when you sell the property in a fully taxable sale are ordinary and can offset ordinary income, including Section 1245 recapture — something capital losses cannot do.

Does the 3.8% NIIT apply to depreciation recapture?

Unrecaptured Section 1250 gain and capital gain on a rental are generally subject to NIIT above the income thresholds. Section 1245 recapture is included for passive investors but generally excluded when the property was used in a non-passive trade or business.

Can a capital loss offset unrecaptured Section 1250 gain?

Yes. Unrecaptured Section 1250 gain is capital gain (capped at 25%), so capital losses can offset it in the same year.

Can a capital loss offset Section 1245 ordinary recapture?

No. Section 1245 recapture is ordinary income, and capital losses can only offset capital gains, not ordinary income.

What if my capital losses exceed my capital gains?

Up to $3,000 of net capital losses per year can offset ordinary income. The rest carries forward to future years.

Sources

Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.