Real Estate Tax Calc
How depreciation works during the lease-option period
A lease-option gives the tenant the right to purchase — but until the option is exercised, you remain the owner and the property is a rental. You continue to depreciate the building each year under the residential rental property rules: the depreciable basis (excluding land) is recovered over 27.5 years using the straight-line method under MACRS (IRC § 168). If the option term is three years, three years of depreciation reduce your adjusted basis before the sale.
Depreciation reduces your adjusted basis in the property dollar-for-dollar. If you purchased a property for $300,000 (with $60,000 allocable to land and $240,000 to building), the annual depreciation is $240,000 ÷ 27.5 = approximately $8,727. After three years, you have claimed roughly $26,181 in depreciation, and your adjusted basis in the building is $240,000 − $26,181 = $213,819. Your total adjusted basis (land + building) is $60,000 + $213,819 = $273,819.
What triggers recapture on exercise
Depreciation recapture is triggered by the disposition of depreciable property. When the tenant exercises the option and title transfers, a taxable sale occurs. All depreciation previously taken on the building — every year, including the option period — is subject to unrecaptured Section 1250 gain and taxed at a maximum rate of 25%.
This is distinct from ordinary Section 1245 recapture, which applies to personal property (equipment, furniture) depreciated beyond straight-line. For residential rental real estate depreciated under straight-line MACRS, all depreciation is Section 1250 gain and is subject to the 25% maximum rate — not ordinary income rates. This makes the tax cost of recapture somewhat predictable: at most 25%, regardless of what marginal bracket the rest of your income falls in, though the Net Investment Income Tax (NIIT) under IRC § 1411 can add 3.8% for higher-income taxpayers.
A worked example: calculating gain and recapture
You purchased a single-family rental for $350,000 in 2022 ($70,000 land, $280,000 building). You entered a three-year lease-option with a tenant-buyer, who exercised the option in December 2025 at the agreed price of $410,000. The tenant paid a $15,000 nonrefundable option fee upfront, and $200 per month was credited toward the purchase price over 36 months ($7,200 in total rent credits).
Annual depreciation: $280,000 ÷ 27.5 = $10,182/year (rounded). Over 3 years: $30,546 total.
Adjusted basis at sale: $350,000 − $30,546 = $319,454.
Amount realized: $410,000 (option strike price) + $15,000 (option fee) + $7,200 (rent credits applied to purchase) = $432,200. Note: the rent and option fee you already reported as ordinary income in prior years are now included in the sales price, but they are not taxed again as gain because they increased your amount realized, not your taxable income in the sale year. The IRS requires careful basis and income tracking to avoid double-counting.
Total gain: $432,200 − $319,454 = $112,746.
Unrecaptured Section 1250 gain: $30,546 (all depreciation taken), taxed at up to 25%.
Remaining long-term capital gain: $112,746 − $30,546 = $82,200, taxed at 0%/15%/20%.
Federal tax estimate (at 15% LTCG, 25% recapture): ($30,546 × 25%) + ($82,200 × 15%) = $7,637 + $12,330 = $19,967, before NIIT and state taxes.
The option fee and rent credits: no double taxation, but careful tracking required
The mechanical complexity of a lease-option sale is that you reported the option fee and rent credits as ordinary income in prior years (under the cash method, when received), and then those same payments are included in the amount realized on the sale. This could look like double taxation — but it is not, because the prior-year income recognition was offset by its effect on the sale calculation.
Here is the safe approach: maintain a ledger that tracks every option payment and rent credit, the year each was included in income, and how each was applied at closing. When computing gain on the sale, include the option fee and credits in the amount realized (they were part of the consideration you received for the property). The prior-year income recognition does not reduce your amount realized; instead, it was its own income event at ordinary rates. The result is that those dollars were taxed as ordinary income when received, and the gain on their ultimate role in the sale price is taxed at capital gains rates to the extent it represents appreciation.
Form 4797 and Schedule D: where to report it
A lease-option property that was a rental is a Section 1231 asset — business-use real property held more than one year. The sale is reported on Form 4797, Part I (Section 1231 gains and losses), with the unrecaptured Section 1250 gain calculated in Form 4797, Part III or on a separate worksheet depending on your software.
The gain flows from Form 4797 to Schedule D. Specifically, the unrecaptured Section 1250 gain (subject to 25% rate) is tracked on the Unrecaptured Section 1250 Gain Worksheet within Schedule D, while the remaining gain is reported as long-term capital gain. The net Section 1231 gain (if positive) is treated as long-term capital gain; if negative, it becomes ordinary loss. For most sellers in a profitable market, the gain will be positive.
If the property was held in a pass-through entity (LLC, S corp, partnership), the gain, recapture, and character flow out on Schedule K-1 and must be reported on the individual return consistent with the K-1 characterization — including the 25%-rate portion shown separately on the K-1.
Suspended passive losses release on sale
If rental losses from the lease-option property were limited by the passive activity rules (IRC § 469) in prior years and remain suspended, those losses are released and become fully deductible in the year of sale. This is one of the more valuable features of a disposition: years of accumulated suspended losses that could not offset active or portfolio income suddenly become available.
Suspended losses are deducted in order: first against any passive income from other activities, then against the gain on the disposition, then against ordinary income. They can materially reduce the tax cost of the sale year, and their release should be factored into any pre-sale tax planning. If you are close to exercising or the tenant seems likely to exercise, running a projection that includes the suspended loss balance can change the net tax picture substantially.
Can a 1031 exchange defer the recapture?
Yes. A qualifying Section 1031 exchange defers both the capital gain and the depreciation recapture into the replacement property's adjusted basis. The deferred gain and recapture do not go away — they are embedded in the replacement property and become due when that property is eventually sold in a taxable transaction — but the indefinite deferral is valuable, especially if the ultimate sale involves a stepped-up basis at death.
To qualify: the sale must be of investment or business-use property (a lease-option rental qualifies), the proceeds must go through a qualified intermediary (you cannot receive the sale proceeds), you must identify a replacement property within 45 days of the sale, and you must close on the replacement within 180 days. Set up the exchange structure before closing — the IRS does not allow retroactive 1031 treatment. Once you have received the sale proceeds, even briefly, the exchange fails.
One complication specific to lease-options: the tenant's exercise date is the effective sale date, so if the exchange timeline is tight, confirm with the intermediary that the identification and closing windows are workable given the lease-option's closing schedule. The intermediary should be engaged before the sale closes, ideally as soon as it is clear the tenant will exercise.
Installment sale as an alternative to lump-sum taxation
If the tenant cannot pay the full purchase price at exercise and the seller agrees to carry part of the note, the sale may qualify for installment sale treatment under IRC § 453. Under the installment method, gain is recognized as payments are received rather than entirely in the year of sale, spreading the tax cost over several years.
However, depreciation recapture — the unrecaptured Section 1250 gain — is not deferred under the installment method. IRC § 453(i) requires that recapture income be reported in full in the year of sale, regardless of how the remaining proceeds are collected. Only the non-recapture gain portion can be spread over the installment period. This limits the utility of installment treatment for heavily depreciated properties, but for a property with modest depreciation and large appreciation, it can still meaningfully defer the capital gain portion.
Frequently asked questions
What tax rate applies to depreciation recapture when a lease-option is exercised?
Unrecaptured Section 1250 gain — the depreciation claimed on the building during the rental years — is taxed at a maximum rate of 25% under current law. This is higher than the 0%/15%/20% rates that apply to long-term capital gain on the remaining appreciation.
Do I have to recapture depreciation even if I took losses I couldn't deduct?
Yes. Depreciation recapture applies to all depreciation allowed or allowable — meaning all the depreciation you were entitled to take, whether or not you actually deducted it. Passive activity losses that were suspended and not used do not reduce the recapture amount; only depreciation that was included in computing gain is affected by actual use.
Can I do a 1031 exchange when my lease-option tenant exercises the option?
Yes, if the sale otherwise qualifies as a 1031 exchange of investment property. You would need to engage a qualified intermediary before closing and identify a replacement property within 45 days of the sale. A successful 1031 exchange defers both the capital gain and the depreciation recapture into the replacement property's basis.
How do I report the sale when the tenant exercises the option?
Report the sale on Form 4797 (Sale of Business Property) for the depreciable rental portion, and any remaining gain on Schedule D. The option fee and rent credits received in prior years are included in the total amount realized on the sale. Depreciation recapture — unrecaptured Section 1250 gain — flows from Form 4797 through to Schedule D and is taxed at up to 25%.
What happens to prior-year passive losses when the lease-option tenant buys?
Suspended passive activity losses from the rental property are released on the disposition and become fully deductible in the year of sale, subject to any at-risk limitations. They offset ordinary income first, then other income — and they can substantially reduce the net tax cost of the sale year.
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.