Real Estate Tax Calc
The setup
Purchase price: $320,000 (land: $64,000; building: $256,000). Capital improvements during ownership: $30,000. Years held: 10. Annual depreciation: $256,000 / 27.5 = $9,309/year; 10 years = $93,090 total claimed. Adjusted basis: $320,000 + $30,000 - $93,090 = $256,910. Net sale price (after selling costs): $500,000.
Breaking down the gain
Total gain: $500,000 - $256,910 = $243,090. This splits into two buckets. Recapture bucket (Section 1250): $93,090, taxed at up to 25% = up to $23,273 in federal tax. Long-term capital gain bucket: $243,090 - $93,090 = $150,000, taxed at 0%, 15%, or 20% depending on your income. At 15%: $22,500. Federal total (before NIIT and state tax): roughly $45,773.
Is claiming depreciation worth it?
The recapture owed ($23,273) often prompts investors to wonder whether taking depreciation was worthwhile. Consider: the $9,309 annual deduction saved approximately $2,048/year in federal tax (at a 22% rate) over 10 years, totaling $20,480. At higher brackets the savings are larger. Critically, IRS taxes recapture on depreciation 'allowed or allowable' — meaning you would owe the $23,273 even if you had never claimed the deductions. So skipping depreciation gives up the savings without eliminating the recapture. Always claim it.
Adding state tax and the 3.8% NIIT to the example
The federal figure of roughly $45,773 is not the whole bill. Most states tax capital gains and recapture as ordinary income with no special 25% cap — so a resident of a state with a 5% income tax on this $243,090 gain would add roughly $12,155. A handful of states (Florida, Texas, Nevada, Tennessee, and a few others) impose no personal income tax on this gain at all. On top of that, because our seller's income likely exceeds the $200,000 single / $250,000 married-filing-jointly threshold in a year with a $243,090 gain, the 3.8% Net Investment Income Tax (Section 1411) applies to the gain — adding about $9,237. Stacked together, the all-in tax can approach $67,000 rather than the $45,773 federal-only figure. Always model federal, NIIT, and state together before you assume you know the number.
How a lower tax bracket changes the result
The '25% recapture rate' is a maximum, not a flat rate. Unrecaptured Section 1250 gain is taxed at your ordinary rate up to a 25% ceiling, computed on the Unrecaptured Section 1250 Gain Worksheet for Schedule D. A retired couple with modest other income might sit in the 12% or 22% ordinary bracket, so their $93,090 of recapture could be taxed closer to 22% (about $20,480) rather than the full 25%. The same low-income year can also drop part of the $150,000 long-term gain into the 0% or 15% capital-gains band. Timing a sale for a low-income year — after retirement, during a sabbatical, or in a year with large offsetting losses — can meaningfully cut the bill on the very same numbers.
Spreading the tax with an installment sale
Selling on an installment note (Section 453) lets you report the capital-gain portion as principal payments arrive, potentially keeping each year's income below the NIIT threshold or out of a higher bracket. Important limits apply to the recapture, however. Any Section 1245 ordinary-income recapture (common when a cost segregation study reclassified components into 5-, 7-, or 15-year property) must be recognized in full in the year of sale under Section 453(i), even if you receive little or no cash that year. The unrecaptured Section 1250 gain from straight-line real-property depreciation can be spread across the installment years, but it is taxed first as gain is recognized. Run the numbers before assuming an installment sale defers the recapture — the ordinary-recapture piece usually cannot wait.
A cost-segregation version of the same sale
Suppose the same owner had commissioned a cost segregation study and reclassified $60,000 of the building into 5- and 15-year property, accelerating those deductions. At sale, that $60,000 of accelerated depreciation is generally Section 1245 property, recaptured as ordinary income with no 25% cap — potentially taxed at 32% or 37% instead of 25%. The remaining straight-line building depreciation stays unrecaptured Section 1250 gain at the 25% ceiling. Cost segregation still usually wins because the accelerated deductions were worth more in the early years (time value of money) and may have offset high-bracket income, but the sale-year math is different from the simple example above. Model the exit, not just the entry.
Common mistakes that inflate the recapture bill
Three errors recur. First, forgetting to add capital improvements to basis — the $30,000 of improvements in our example raised basis and cut the gain; leaving them off overstates the tax. Second, using the full purchase price as depreciable basis instead of carving out non-depreciable land ($64,000 here) — over-depreciating land inflates recapture with no offsetting deduction benefit. Third, netting selling costs incorrectly: commissions, transfer taxes, and title fees reduce the amount realized, lowering the gain. Keep closing statements from both purchase and sale, an improvements log, and your depreciation schedules (Form 4562 history) so every number on the recapture worksheet is supportable.
Where the sale is reported: Form 4797 and Schedule D
A rental sale is not a simple Schedule D transaction. Gain on real property used in a trade or business is first computed on Form 4797 (Sales of Business Property). The Section 1250 portion flows through the Unrecaptured Section 1250 Gain Worksheet and onto Schedule D, where the 25%-maximum rate is applied. Any Section 1245 ordinary recapture is reported directly as ordinary income in Form 4797 Part III. The depreciation you claimed is pulled from your cumulative Form 4562 history. Because the numbers move across several forms, most sellers work the sale with a CPA or reputable tax software rather than by hand — an error on any one form changes the tax owed.
Planning moves before you sell
If the projected recapture and capital-gain tax is unwelcome, several tools can defer or reduce it. A 1031 exchange into a like-kind replacement defers the entire gain — recapture included — into the new property's basis. Suspended passive losses from this or other rentals release in the year of a fully taxable sale and can offset the gain dollar for dollar. Careful timing can shift the sale into a lower-income year. And holding until death gives heirs a stepped-up basis that erases the built-in recapture entirely. The right move depends on whether you want to stay invested, need liquidity, or are planning your estate — decide before you list, because most of these tools cannot be applied after closing.
Reading the unrecaptured Section 1250 gain worksheet
The mechanics that produce the '$23,273 at up to 25%' in our example live in the Unrecaptured Section 1250 Gain Worksheet in the Schedule D instructions. In plain terms: it takes the smaller of your total straight-line real-property depreciation ($93,090) or your total gain on the property, and channels that amount into a special 25%-maximum bucket. The rest of the gain ($150,000) flows to the regular long-term capital-gains lines. The worksheet then feeds the Schedule D Tax Worksheet, which stacks your income and applies the 0/15/20% capital-gains brackets and the 25% ceiling in the correct order. You rarely fill this out by hand, but understanding it explains why the recapture is taxed differently from the rest of your gain — and why the 25% is a cap, not a flat rate.
How a partial disposition changes the numbers
Our example assumed a clean sale of the whole property. If during the hold you replaced a major component — say the original $20,000 roof — you may have made a partial disposition election to write off the remaining basis of the old roof when you removed it. That election reduces the depreciation still 'inside' the property at sale and can lower the recapture figure accordingly, because you already recognized the loss on the retired component. Conversely, capital improvements you added (like the $30,000 in our setup) begin their own depreciation schedules and add their claimed depreciation to the recapture pool. Tracking each component — what was added, what was retired, and how much depreciation each carried — is what makes the final recapture number on Form 4797 accurate rather than a guess.
A quick recap of the numbers
Pulling the example back together: a $320,000 purchase (with $30,000 of improvements) held 10 years, depreciated $93,090, and sold for a net $500,000 produced a $243,090 gain. That gain split into $93,090 of unrecaptured Section 1250 gain taxed at up to 25% (about $23,273) and $150,000 of long-term capital gain (about $22,500 at 15%), for roughly $45,773 of federal tax — before the 3.8% NIIT and state income tax that can push the all-in figure toward $67,000. The lesson is not that depreciation is a trap: the deductions saved real tax every year, the recapture would apply whether or not you claimed them, and tools like a 1031 exchange, suspended-loss offsets, or a step-up at death can defer or erase the bill entirely. Know your numbers before you sell.
Frequently asked questions
How do I calculate depreciation recapture on a rental sale?
Total gain = sale price minus adjusted basis. Recapture = the lesser of total gain or total depreciation claimed, taxed at up to 25%. Any remaining gain is long-term capital gain.
Does taking depreciation cause a bigger tax bill at sale?
Yes on recapture — but the annual tax savings from depreciation deductions over the hold period typically outweigh the recapture cost, especially for long holds and higher tax brackets.
Is depreciation recapture always taxed at 25%?
No. The 25% figure is a ceiling on unrecaptured Section 1250 gain from straight-line real-property depreciation. If your ordinary rate is below 25%, you pay the lower rate. Section 1245 recapture on cost-segregated components has no cap and is taxed at your full ordinary rate.
Do I owe state tax and NIIT on the recapture too?
Usually yes. Most states tax the gain as ordinary income with no special rate, and high earners owe an extra 3.8% Net Investment Income Tax on the gain and recapture. Together these can add tens of thousands beyond the federal capital-gains and recapture tax.
Can a 1031 exchange avoid the tax in this example?
A 1031 exchange defers the entire $243,090 gain — both the recapture and the capital gain — by rolling it into a replacement property's lower basis. It does not erase the tax; it postpones it until you sell without exchanging, or eliminates it if you hold until death and heirs take a stepped-up basis.
Sources
- IRS Topic No. 409 — Capital Gains and Losses
- IRS Publication 544 — Sales and Other Dispositions of Assets
- IRS Publication 946 — How to Depreciate Property
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.