Depreciation Recapture: Why Your Gain at Sale Isn't All Capital Gain

Depreciation is a timing benefit, and the exit is when the timing ends

Every year you own a short-term rental, depreciation reduces your taxable income. In a year when you can use those deductions right away, they offset income otherwise taxed at ordinary rates — the highest rate you pay — and that is genuinely valuable. Whether you can use a given year's deduction right away is a separate question. Passive-activity limits (rules that generally let losses from passive activities offset only passive income) and other limitations can suspend it to a later year. Either way, depreciation does not make the money tax-free. It moves the tax.

It is easier to see how this works through basis. Your adjusted basis starts at what the property cost you, rises with capital improvements and falls with every dollar of depreciation (§1016(a)(2)). Your gain on a sale is the amount realized minus adjusted basis (§1001(a)). The amount realized is, broadly, the full price you sell for, less selling costs; paying off your mortgage from the proceeds does not reduce it. So a dollar deducted while you own the property is a dollar of extra gain waiting when you sell — automatically, as a matter of arithmetic, whether or not anyone planned for it. Depreciation does not so much reduce your lifetime tax on the property as reschedule it: a deduction now, a larger gain later.

Recapture is the other half of that arrangement. Without it, the rules above would let you take deductions against income taxed at ordinary rates and then settle up at long-term capital gain rates. That would change the character of the income — the category that decides how it is taxed — and not just its timing. The recapture rules exist to stop that. At disposition — when you sell or otherwise dispose of the property — they ask a specific question: how much of this gain is just the depreciation coming back? And they tax that portion differently from the rest.

This is educational information about how the recapture rules work, not individualized tax advice. How they apply turns on your depreciation schedule, your asset classes and your actual disposition, and should be confirmed with your own qualified tax professional.

One property, two regimes

The first thing to understand is that recapture is not one rule applied to one number. Your property is a collection of assets, and each one falls under one of two sets of rules in the tax code — two regimes that behave very differently.

§1245 property is, broadly, depreciable personal property. In tax terms, "personal property" means property that is not real estate; it has nothing to do with personal use. Think appliances, furniture, carpeting, cabinetry, specialty electrical and plumbing, and equipment. In a short-term rental this category is large, and a cost segregation study makes it larger on purpose.

§1250 property is depreciable real property that is not §1245 property — principally the building itself.

Land is in neither, because land is not depreciated. There is no recapture on the part of the price allocated to land; gain attributable to land is simply capital gain.

This is the same split Adjusted Basis: The Number That Determines Your Exit Tax describes as "several ledgers rather than one," and this is where that structure starts to matter. Adjusted basis tells you how much gain there is. The regime each ledger sits in tells you what kind of gain it is — and the difference between the two answers can be many percentage points of tax.

For one sale worked through figure by figure, see What the Tax Bill Actually Looks Like When You Sell an STR. Under the price allocation that example assumes, a $260,000 gain divides into $30,000 of §1245 ordinary-income recapture, $0 of §1250 ordinary recapture (the building was depreciated straight-line), $80,000 of unrecaptured §1250 gain and $150,000 of remaining §1231 / long-term capital gain (the gain left after the depreciation-related pieces; §1231 is explained below).

§1245: the fast components come back as ordinary income

For §1245 property, the rule is blunt. When you sell at a gain, the gain is treated as ordinary income to the extent of all depreciation allowed or allowable on that asset (§1245(a)). Not just the excess over straight-line. Not a portion. All of it, up to the amount of gain. Depreciation you were entitled to take but did not claim still lowers your basis, so it still adds to your gain (§1016(a)(2)). But if your records establish that you claimed less than you were entitled to claim, the ordinary recapture is generally measured by what you actually claimed, and the rest of that gain is not §1245 recapture (§1245(a)(2)(B)). Both points are worth confirming with your tax professional.

Three features of that rule matter for a short-term-rental owner.

It is taxed at ordinary rates. §1245 recapture gets no preferential (lower) rate and no 25 percent ceiling. It is added on top of your other ordinary income and taxed accordingly. Owners who have heard "recapture is 25 percent" have heard something about a different regime, and applying that number here will understate the bill.

It counts accelerated depreciation in full. Bonus depreciation under §168(k) and expensing under §179 can each let you deduct much or all of an asset's cost in its first year, and both are still depreciation for this purpose. An asset written off entirely in year one has been depreciated to zero, so essentially the whole of any gain on it is ordinary income. The faster the write-off, the more complete the recapture.

And it applies asset by asset, not to the property as a whole. Each item on the depreciation schedule — the running list of every asset you depreciate and the depreciation taken on it — carries its own recapture calculation. That is why the schedule matters so much. A schedule that was never kept up to date is not just a paperwork issue; it becomes a real problem at closing.

A related rule is worth knowing even though it applies before any sale. If business use of §179 property drops to 50 percent or less, part of the expensing is recaptured — added back to your income — in that year (§179(d)(10)). An STR that switches to substantial personal use is the obvious way an owner triggers that rule without selling anything.

§1250: the building comes back too — at its own rate

Here is the part that surprises people who thought they had avoided the problem by depreciating the building slowly.

Real property placed in service after 1986 (first put into use after that year) is depreciated straight-line. So there is generally no "additional depreciation" — no excess over straight-line — and therefore generally little or no §1250 ordinary recapture on the building. That much is good news, and it is where most explanations stop.

But a separate rule picks it up. The portion of your long-term capital gain attributable to prior straight-line depreciation on real property is unrecaptured §1250 gain, and for tax year 2026 it is taxed at your ordinary rate subject to a 25 percent ceiling (§1(h)). Read the ceiling as a maximum rather than a flat rate: 25 percent is the most it can be taxed at, not automatically what every dollar of it costs. It is still capital gain — it is not ordinary income, and it is not §1245 recapture — but it does not receive the 0, 15 or 20 percent rates that apply to the remaining long-term capital gain.

So the accurate statement is that depreciation on the building comes back as well. It comes back in a gentler form and at a capped rate, but no version of straight-line depreciation leaves nothing behind at the exit. Depreciating slowly changes the tax rate at which the building's depreciation comes back. It does not stop it coming back.

Land improvements: the piece that behaves like neither

Between the two sits a category most STR owners have and few think about: land improvements — driveways, fencing, pools, decking, landscaping, exterior lighting. A cost segregation study typically assigns these a 15-year recovery period, meaning their cost is depreciated over that many years.

These are generally §1250 property rather than §1245, so the §1245 rule above, which treats gain as ordinary income up to all the depreciation taken, does not simply apply to them. But unlike the building, they are depreciated on an accelerated method, which front-loads the deductions, rather than straight-line, and they are frequently eligible for bonus depreciation. That means, unlike the building, they can carry additional depreciation — depreciation in excess of what straight-line would have produced — which is precisely what §1250 ordinary recapture reaches.

We are flagging this rather than resolving it, deliberately. How much of a given owner's land-improvement depreciation is additional depreciation, and how the resulting gain is characterized on their particular disposition, depends on the method actually used, the bonus depreciation percentage for the year the improvements were placed in service, and the facts of the sale. It is a genuine question for your tax professional and one of the more common places a do-it-yourself estimate goes wrong. What you should take from this page is that the pool and the driveway do not automatically get the same treatment as the building.

Recapture cannot exceed gain — but "gain" is measured asset by asset

Recapture has one important limit, and it is the only real relief in it. It is also the limit most often misread, because the natural instinct is to apply it to the property as a whole.

Recapture applies only to gain. §1245 changes the character of gain to ordinary income; it does not create income where there is none. An individual depreciated asset sold at a loss produces no recapture on that asset, because there is no gain for §1245 to reach. Unrecaptured §1250 gain works the same way — it is a slice of capital gain, and if there is no capital gain there is no slice.

Now apply that to a short-term rental, which is not one asset but a collection of them. Selling the property is a sale of many assets at once: the price is allocated among the assets, and gain or loss is computed separately for each. So an overall loss on the property does not necessarily mean zero recapture. Individual §1245 components — the furnishings and short-life assets a cost segregation study wrote down toward zero — can still be allocated more of the price than their adjusted basis. Each of those produces ordinary recapture on its own, whatever the deal as a whole did economically.

That is the same asset-by-asset ledger structure this page opened with, showing up where it matters most. "I did not really make anything on this sale" is a statement about the whole property and its economics. The recapture calculation is neither of those: it runs down the depreciation schedule, asset by asset, against an allocation of the price. A property that sells for roughly what you paid for it has still generated substantial taxable gain on individual ledgers, because their basis fell every year you held it.

Once recapture has taken its portion, what remains on business property held more than a year is generally §1231 gain, which is treated as long-term capital gain. That treatment carries its own wrinkle: §1231(c) looks back five years, and net §1231 losses claimed as ordinary in that window recharacterize a corresponding amount of this year's gain as ordinary. The 3.8 percent net investment income tax under §1411 is a separate layer: where it applies, it reaches the whole gain, ordinary recapture included, not only the capital-gain pieces. Whether it applies depends on your modified adjusted gross income and on the activity, and gain is generally excluded only where the property was held in a qualifying §162 trade or business that is non-passive to you. This page is about character; the assembled bill, with rates and stacking, is laid out in What the Tax Bill Actually Looks Like When You Sell an STR.

What a cost segregation study actually traded

It should now be clear what a cost segregation study (Is Cost Segregation Worth It for My STR?) does at both ends of your ownership — while you hold the property and when you sell — and it is worth stating plainly, because the sales pitch usually covers only one end.

A study moves basis out of the 27.5-year building and into 5-, 7- and 15-year classes, which are depreciated faster. During the hold, that speeds up deductions against ordinary income — a real benefit, and often a large one, especially where the owner can use those losses in the year they arise. At the exit, the same reallocation means a larger share of your gain sits in the shorter-life ledgers that recapture as ordinary income, rather than in the building's ledger, which returns as capital gain under a 25 percent ceiling.

So the trade is a timing-and-rate trade: deductions now at ordinary rates, against a portion of the gain later at ordinary rates. Whether that comes out ahead depends on the time value of the deferral (what it is worth to pay tax later rather than now), whether the deductions were usable when taken, the owner's rates in both periods, and how the property is eventually disposed of. For many operators it still does come out ahead. Our point is not that cost segregation is a bad idea. It is that the exit consequence is part of the calculation and is routinely left out of it. An owner who models the study's benefit without modeling the recapture is counting the benefit and leaving out its cost.

Where recapture follows you

Recapture attaches to the property's depreciation history, so it travels with the property through most of the exits an owner considers.

A 1031 exchange defers it. Roll into a replacement property and the gain — recapture included — is generally deferred rather than eliminated, carried forward in the reduced basis you take in the new property. There is an important limitation for cost-segregated owners: since 2018, §1031 applies only to real property. Property that is personal property under the §1031 rules is generally not eligible for like-kind exchange treatment, so gain attributable to it, including ordinary §1245 recapture, can be recognized even inside an otherwise successful exchange. A cost segregation study's §1245 label does not answer that question by itself: whether a component is real property for §1031 is decided under its own regulations (Treas. Reg. §1.1031(a)-3), asset by asset, and some §1245 components can still be real property. The 1031 Exchange for Short-Term Rentals works through that classification; settle it with your advisor before the exchange, not after.

An installment sale does not spread it. In an installment sale the buyer pays you over time, but under §453(i) the ordinary depreciation-recapture income is generally recognized — included in your taxable income — in the year of sale, regardless of when you are paid. That can produce a real year-one tax bill while most of the price is still outstanding. Selling Your STR on Installments: What Gets Deferred, and What Doesn't covers that in full.

Death ends it. A basis step-up at death under §1014 resets basis to date-of-death value for the heir, and the built-in gain — recapture included — that accumulated during the owner's life is not taxed to them. That is the one exit where the accumulated tax liability disappears rather than moving. It is a consequence of still holding the property, not a strategy anyone executes (What Happens to an STR's Tax Basis When You Die? explains why).

It is computed from the schedule, not estimated from the price

Everything above is calculated from your depreciation schedule, asset by asset, and the quality of that schedule decides whether the number you get is right.

That means the schedule needs to be accurate and current:

• each asset class carried separately
• the cost segregation study retained with its allocations
• bonus and §179 elections recorded (the choices on your return to claim §179 expensing or to opt out of bonus depreciation)
• components that were replaced actually removed from the schedule rather than left on it

That last one is worth its own sentence. When you replace a roof or an HVAC system, a partial-asset-disposition election — a choice on your return to treat the removed component as disposed of — lets you write off that component's remaining basis. Just as importantly, it takes the component off the schedule, so it is not still sitting there generating recapture on an asset that no longer exists.

The owner with a clean schedule can model an exchange against real numbers, decide between selling and refinancing on facts, and see the year-one number before agreeing to installment terms. The owner without one finds out how the gain was split into its tax categories only after the return is filed.