Knowing your depreciation recapture number before you list lets you price the sale on what you keep after tax. Depreciation recapture is the part of your gain the IRS taxes because you deducted depreciation while you owned the rental. On a short-term rental that usually splits two ways: gain tied to furniture, appliances and other personal property is taxed as ordinary income, and gain from depreciation on the building is taxed at a maximum 25 percent rate.
Everything you wrote off comes back into the math at closing, including depreciation you were allowed to take and never claimed. A seller-financed note does not push it into later years. A 1031 exchange can defer it.
In my experience, the surprise shows up the same way every time. An operator takes a cost segregation study, writes off most of the furniture and fixtures in year one, enjoys four or five years of low tax bills, then accepts an offer and learns from the CPA that a large slice of the gain is taxed at ordinary rates. The deduction was real. It was also a timing benefit, and the exit is where the timing ends.
I've spent 18+ years in real estate and have focused on short-term rentals since 2016. The operators who keep the most from a sale knew their adjusted basis, their recapture buckets and their exit options before they signed a listing agreement.
This guide walks through how recapture works on a furnished rental, a worked sale, the exit paths that change the timing, and a five-step process to run before you list.
How Depreciation Recapture Works on a Furnished Rental
Your gain on a sale is the amount you realize minus your adjusted basis. Basis generally starts as what you paid, and certain events during ownership raise or lower it before you figure gain or loss on a sale (IRS Topic 703). Depreciation is the biggest downward adjustment on most rentals.
The US rules for recapture sit in Sections 1245 and 1250 of the Internal Revenue Code, and gain above the recomputed basis is taxed as capital gain under Section 1231 (Wikipedia). For an operator, that means sorting the property into two groups.
Section 1245 property is the personal property: furniture, appliances, electronics and similar items. When you sell it, the amount by which the lower of its recomputed basis or the amount realized exceeds its adjusted basis is treated as ordinary income (26 U.S.C. § 1245). Ordinary income is taxed at your regular bracket, not a capital gains rate.
Section 1250 property is the building. Unrecaptured Section 1250 gain from selling the building is taxed at a maximum 25 percent rate (IRS Topic 409). Gain beyond that is long-term capital gain, taxed at 0, 15 or 20 percent depending on taxable income.
A cost segregation study moves dollars from the second group into the first. A study identifies construction-related costs that can be depreciated over shorter lives, typically 5, 7 and 15 years, instead of the building's life (Wikipedia). The same article lists recapture among a study's downsides.
With bonus depreciation, the IRS allows a 100 percent special depreciation allowance for qualified property acquired and placed in service after January 19, 2025 (IRS Topic 704).
For the front end of that decision, see maximizing STR cost segregation benefits and the 100% bonus depreciation guide. This article is about the back end.
Depreciation You Never Claimed Still Counts
This is the trap that catches self-prepared returns. The adjusted basis under Section 1016 is reduced for depreciation "allowed or allowable" (Wikipedia; 26 U.S.C. § 1016).
Allowable means the depreciation you were entitled to take. If you owned a rental for five years and never claimed depreciation, the basis is still reduced as if you had. You can end up paying recapture on deductions you never used.
The fix is to catch up on missed depreciation before you sell. Form 3115 is the IRS application for a change in accounting method (IRS), and the cost segregation literature notes that the rules allow taxpayers to take the entire adjustment in the year a retroactive study is completed (Wikipedia).
Ask your CPA whether a catch-up belongs on this year's return, while you still own the property and can use the deduction.
A Worked Sale: Where the Gain Lands
Here is an illustrative example. The figures in this article, tables and prose examples are for explanation only and are not tax advice. Your numbers depend on your purchase price allocation, depreciation methods, holding period and bracket.
An operator buys a furnished beach rental for $500,000. Land is $100,000 and the building and contents are $400,000. A cost segregation study reclassifies $80,000 as furniture, appliances and fixtures, and the operator deducts all $80,000 in year one with bonus depreciation. Over five years the building itself takes $58,000 of straight-line depreciation.
Total depreciation is $138,000, so adjusted basis is $362,000. The operator sells for $600,000 with $36,000 of selling costs, so the amount realized is $564,000 and the total gain is $202,000.
The purchase agreement allocates $15,000 of the price to the furnishings. Their adjusted basis is zero after bonus depreciation, so that $15,000 is Section 1245 gain. The rest of the gain belongs to the land and building:
Bucket | Gain | Top rate |
|---|
Contents | $15,000 | Ordinary |
Building | $58,000 | 25% |
Rest | $129,000 | 20% |
Total | $202,000 | Mixed |
"Contents" is the Section 1245 gain on the furnishings. "Building" is the unrecaptured Section 1250 gain, equal to the straight-line depreciation taken on the structure. "Rest" is the long-term capital gain above that, shown at the top 20 percent rate. The three rows add to $202,000.
Notice what the allocation did. The operator deducted $80,000 on the contents but only $15,000 comes back as Section 1245 ordinary income, because the statute caps it at the amount realized for that property. In my experience, used furniture sells for a fraction of what it cost, which is why the allocation in the contract matters.
An allocation that does not reflect fair value is a problem in an audit, so set it from an appraisal or a documented inventory, not from what produces the lowest tax.
One more layer. A 3.8 percent net investment income tax applies to individuals with net investment income above threshold amounts: $200,000 of modified adjusted gross income for single filers and $250,000 for married couples filing jointly (IRS Topic 559). Whether rental gain counts as investment income depends on how you operated the property, so ask your CPA whether it applies to your sale.
The gain is reported on Form 4797 (IRS), the form for sales of business property.
Exit Paths That Change the Timing
The sale structure does not erase recapture, but it changes when and whether it lands. Here is how the common paths compare. "Taxed" shows when the recapture is taxed:
Exit | Taxed | Rule |
|---|
Sale | Year one | 4797 |
Seller note | Year one | 453(i) |
1031 swap | Later | 1031 |
Inherit | Reset | 1014 |
Outright sale. Every bucket is taxed in the year of sale.
Seller financing. An installment sale spreads the capital gain over the years you collect principal, but recapture income is recognized in the year of the disposition, and only the gain in excess of recapture income goes on the installment method (26 U.S.C. § 453). You can owe tax on recapture in year one while most of the cash arrives later.
If you are weighing a note, read seller financing terms for an STR's slow season with this in mind, and size the down payment to cover the first-year bill.
1031 exchange. Exchanging into like-kind real property defers gain, recapture included, to the extent you receive only like-kind real property and as long as the exchange follows the rules (26 U.S.C. § 1031). Like-kind treatment applies to real property, so the furniture in the sale does not qualify. Personal use of a vacation property can also disqualify it; see 1031 exchange limits for short-term rentals with personal use.
Hold until death. Property acquired from a decedent generally takes a basis equal to its fair market value at the date of death (26 U.S.C. § 1014). The depreciation taken during life does not come back to the heirs as recapture. That is an estate planning choice, and it belongs in a conversation with your attorney.
Price the Exit Before You List: A Five-Step Process
Run this before you call a listing agent. It turns a vague "we'll owe something" into a number you can plan around.
Step 1 — Pull the Full Depreciation Schedule
Get every year's depreciation schedule from your returns, plus the cost segregation report if you had one. List what was placed in service, when, the method and the total taken. Flag any year where no depreciation was claimed; those years still reduce basis.
Step 2 — Split the Basis Into Buckets
Separate land, building, personal property and any improvements. Write down the adjusted basis of each. Your CPA needs this split to calculate Section 1245 gain, unrecaptured Section 1250 gain and the capital gain above it.
Step 3 — Document What the Contents Are Worth
Inventory the furniture, appliances and electronics that convey with the sale and get a supportable value. That value becomes the allocation in the purchase agreement and sets your Section 1245 number. Agree on the allocation with the buyer in writing before closing.
Step 4 — Model the Tax Under Each Exit
Have your CPA run the bill for an outright sale, a seller note and a 1031 exchange using your real numbers. Compare total tax and after-tax cash in year one. A seller note with a thin down payment can leave you short in the year you owe recapture.
Step 5 — Set Aside Cash for the Tax Year of Sale
Set aside the estimated recapture and capital gains tax from the closing proceeds the day the sale funds. Ask whether estimated tax payments are due that quarter so you are not paying a penalty on top of the bill.
If you want a second set of eyes on the numbers before you commit to an exit, book a complimentary one-on-one diagnostic call. We'll look at your portfolio's cash flow and where a sale fits in your plan.
Mistakes That Make Recapture Worse
Taking a study with a short hold. Accelerated depreciation pays off when you hold long enough for the deferral to be worth something. If you expect to sell within a few years, model the recapture before you order the study.
Letting the buyer set the allocation. A buyer generally benefits from a higher allocation to personal property, because it can be depreciated faster than the building. That same allocation raises your ordinary income. Negotiate it like price.
Skipping depreciation to "avoid" recapture. It does not work. Allowable depreciation reduces basis whether you claimed it or not, so skipping it gives up the deduction and keeps the recapture.
Assuming the note spreads everything. Section 453(i) puts recapture income in the year of sale. Plan the down payment around it.
Forgetting state tax. State income tax may apply to the gain as well. Add your state rate to the model.
Records to Keep From Day One
Recapture is a records problem as much as a tax problem. The operators I work with who close cleanly keep a single folder per property with:
The closing statement and purchase price allocation from the purchase.
Every depreciation schedule, by year.
The cost segregation report and any updates after renovations.
Receipts for furniture, appliances and improvements, with placed-in-service dates.
Records of any assets disposed of or replaced during ownership.
When an asset is thrown out or replaced mid-ownership, tell your CPA that year. Leaving retired furniture on the schedule overstates the depreciation still to come and confuses the basis at sale.
Frequently Asked Questions
What is depreciation recapture on a rental property?
It is the part of your gain on a sale that the IRS taxes because you took depreciation while you owned the property. Gain tied to personal property such as furniture is taxed as ordinary income under Section 1245, and gain from depreciation on the building is taxed at a maximum 25 percent rate.
Can I avoid depreciation recapture by not claiming depreciation?
No. Basis is reduced by depreciation allowed or allowable, so the recapture applies even if you never claimed the deduction. Ask your CPA about a catch-up with Form 3115 before you sell.
Does a seller-financed sale defer depreciation recapture?
No. Under Section 453(i), recapture income is recognized in the year of the sale even when the buyer pays over time. Only the gain above the recapture income is spread over the payment years.
Does a 1031 exchange avoid depreciation recapture?
A qualifying exchange into like-kind real property defers it rather than removing it. The deferred gain carries into the replacement property, and furniture sold with the rental does not qualify for like-kind treatment.
How is depreciation recapture reported?
The sale of business property, including rental real estate and its contents, is reported on Form 4797. Your CPA uses your depreciation schedules to split the gain into its buckets.
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