Rental Property Depreciation Recapture and Form 4797

How is depreciation recapture taxed when I sell a rental property?

Depreciation recapture is the tax on the part of your gain that comes from the depreciation you took, or could have taken, on the rental. For a rental held more than one year, the layer that matches the building's depreciation is taxed at a maximum of 25%, and the rest of the building and land gain is long-term capital gain (IRS Topic 409; Publication 544).

Ordinary-income recapture applies to real property depreciated faster than straight line or with a special depreciation allowance. A residential rental building placed in service after 1986 is generally depreciated straight line over 27.5 years (Publication 527), and the Form 4797 instructions exclude that class of property from it. Other parts can still recapture as ordinary income: personal property such as carpet and appliances, up to all the depreciation taken, and faster-depreciated real property parts, for the excess over straight line (the rest stays in the 25% layer) (Publication 544).

A sale is not simple when any of these apply:

• You claimed bonus or other accelerated depreciation on any part of the property, or split it into shorter-lived parts (a cost segregation study).
• You had net section 1231 losses (losses on rental and business property held over a year) in the previous five years. A net gain is ordinary income up to those losses (Publication 544).
• You never took depreciation, are unsure what you took, or your books cannot show cost, improvements and depreciation.
• The rental is under contract or about to close.
• The buyer is a relative or your own entity.
• You are owner-financing, exchanging, or carrying suspended passive losses (each is below).

Gather the purchase and sale closing statements, the sale contract and any note or exchange agreement, the depreciation schedule for every year, a dated list of improvements with costs, the loan payoff statement, and any passive loss carryovers.

An exchange or owner financing is set up before closing: money you receive before the replacement property can turn an exchange into a sale (Publication 544).

What is unrecaptured section 1250 gain, and what is the top rate?

Unrecaptured section 1250 gain is the part of long-term gain on depreciated real property that is due to depreciation, and its maximum rate is 25% (IRS Topic 409). It cannot include gain treated as ordinary income, and for section 1231 property it cannot exceed the net section 1231 gain (Publication 544). A rental reported on Form 8949 instead is figured on the same worksheet without the section 1231 cap.

The amount is the smaller of the depreciation allowed or allowable on the building and the building's total gain, less any ordinary recapture. Enter it on Schedule D, line 19, using the Unrecaptured Section 1250 Gain Worksheet in the Schedule D instructions.

The 25% figure is a maximum: the Schedule D Tax Worksheet figures the tax on this layer together with the rest of your income. The top long-term capital gain rate of 20% applies above taxable income of $545,500 for single filers or $613,700 for joint filers in this tax year. Head of household and married filing separately have their own thresholds (Revenue Procedure 2025-32).

Do I owe depreciation recapture if I never took depreciation?

Recapture is figured on the depreciation you could have taken, even if you took none. The IRS says to reduce basis by the depreciation you could have deducted, and if you took none, by the full amount you could have taken (Publication 551).

Unrecaptured section 1250 gain and ordinary recapture both use depreciation "allowed or allowable", so skipping the deduction does not skip the tax layer (Form 4797 instructions; Schedule D instructions). If years were missed, the fix has its own forms and timing: see missed depreciation on a rental.

How do I work out the gain: sale price, selling costs and adjusted basis?

The gain is the amount realized, less selling expenses, less adjusted basis (Publication 544).

1. Amount realized. The cash, plus the value of anything else you receive, plus any mortgage or other debt the buyer takes over or the property is sold subject to. A mortgage paid off at closing is part of this figure, so the cash you leave with is not the gain.
2. Selling expenses. Subtract them from the amount realized.
3. Adjusted basis. Cost, plus improvements that last more than a year, minus depreciation allowed or allowable (Publication 551).
4. Gain or loss. Step 1, minus step 2, minus step 3.

Land cannot be depreciated, so split the price, selling costs and basis between land and building. Form 4797 reports the building in Part III and the land in Part I (Form 4797 instructions). Which closing-statement lines add to basis, and how to split land from building, is in rental closing statements in the books.

Which forms report the sale: Form 4797, Form 8949 and Schedule D?

A rental sale is generally reported on Form 4797, with the net gain carried to Schedule D. For section 1231 purposes, property held to produce rent is generally treated as used in a trade or business (Publication 544).

The closing agent's Form 1099-S shows gross proceeds, and the Form 4797 instructions tell you to enter it on line 1a. Whether a rental rises to the level of a trade or business is a facts question, and the instructions do not settle it for a particular rental. A rental that is not a trade or business is a capital asset reported on Form 8949, with only the recapture computed in Part III (Form 4797 instructions).

What do I do in the year of sale: last depreciation and the books?

Take depreciation for the part of the year you owned the rental, then remove the property from the books and tie the gain to the tax forms.

In the year of sale, depreciation is only part of a full year. A residential rental uses the mid-month convention, which counts the month of sale as half a month (Publication 946). A sale on March 2 earns 2.5 months of that year's depreciation. Appliances and furniture use the half-year or mid-quarter convention instead (Publication 946).

To close out the books:

1. Post rent and expenses through the closing date.
2. Record the sale from the closing statement: cash received, selling costs, the mortgage payoff and the buyer's share of prorations. If the buyer signs a note, record it as a receivable and reduce it as principal arrives.
3. Remove land, building and improvement costs, and the accumulated depreciation, from the asset accounts.
4. The difference is the book gain or loss. It matches the Form 4797 gain, before any installment deferral or exchange, only if the books carried the same basis and depreciation as the return. If it does not, find out why before the return is prepared.
5. Keep the closing statements and the depreciation schedule. The IRS tells you to keep permanent records of depreciation allowed or allowable (Publication 544).

The gain is taxed for the year of sale. Tax is pay-as-you-go, so a large gain can mean estimated payments that year and a penalty if they fall short (IRS Topic 306); the dates are in quarterly estimated tax payments.

I am owner-financing the sale: is recapture spread over the payments?

Ordinary recapture, such as on appliances or accelerated depreciation, is all reported in the year of sale, even if no payment arrives that year (Publication 537; Publication 544). The depreciation layer on a straight-line building can use the installment method, but it comes out of the first payments: the gain in each payment counts toward that layer until it is used up, so a large down payment can bring all of the 25% layer into the year of sale (26 CFR 1.453-12; Schedule D instructions). Only gain above the ordinary recapture can use the installment method.

• Form 6252 reports the sale each year, and its gain goes to Form 4797 or Schedule D.
• Electing out means reporting the whole gain in the sale year, filed by the sale-year return due date, including extensions (Publication 537).
• A mortgage the buyer takes over counts as a payment in the sale year to the extent it is more than your installment sale basis: adjusted basis plus selling costs plus any ordinary recapture income. After depreciation that is common, and it can bring much of the gain, including the 25% layer, into the sale year (Publication 537).
• Interest on the note is ordinary income each year, separate from the gain. If the contract states too little interest, part of the price is treated as interest (Publication 537).
• A buyer who is your controlled entity or a trust you or your spouse benefit from, among other related persons, generally cannot use the installment method for depreciable property; all payments are treated as received in the year of sale (Publication 537).

Can a 1031 exchange defer the tax?

A like-kind exchange of real property held for business or investment, for other such real property, can defer the gain, including the depreciation layer. Cash, other property and mortgage relief you receive make gain taxable now, up to the amount of the gain. Mortgage relief is the debt the other side takes over, less the debt you take on and any cash or other property you add (Form 8824 instructions). Only real property qualifies, so furniture and other personal property sold with the rental is generally taxed as a sale, including ordinary recapture on it (IRS: like-kind exchanges; Publication 544).

The timing comes from the Form 8824 instructions. Two traps:

• If you actually or constructively receive the sale money before you receive the replacement property, the deal is treated as a sale, or as a partly taxable exchange if you receive only part of it (Publication 544). An exchange is generally set up before the sale closes, and who holds the sale money decides whether the transfer counts as a sale.
• Property held mainly for sale does not qualify, and US property is not like-kind to property abroad (IRS: like-kind exchanges).

Deferral is not forgiveness. The replacement generally takes the old property's basis, and the gain is recognized when you later sell it without another exchange (Publication 544). If either side of an exchange with a related party disposes of the property within 2 years, the deferral generally ends (Form 8824 instructions). For exchanges into a syndication or an opportunity zone fund, see the 1031 and opportunity zone guide.

Does the net investment income tax apply to the gain?

It can. Gain from selling a rental is net investment income unless the rental is a nonpassive trade or business, and the tax applies only above an income threshold (IRS Topic 559).

The tax is 3.8% of the lesser of net investment income or the amount by which modified adjusted gross income exceeds $200,000 (single or head of household), $250,000 (married filing jointly or qualifying surviving spouse) or $125,000 (married filing separately).

For this tax, a rental is passive even if you work at it a lot, with limited exceptions. The gain is not net investment income when the rental is a section 162 trade or business and is nonpassive for you, for example for a real estate professional who materially participates. A real estate professional who meets the safe harbor (more than 500 hours in each rental activity in the year of sale, or in 5 of the prior 10 years) is outside the tax on the gain. Being a real estate professional alone is not enough: the rental must also be a trade or business (Form 8960 instructions). Form 8960 figures the tax. It is separate from the capital gain rates above. For the rent side of this tax, see rental property taxes.

What happens to suspended passive losses when I sell?

Suspended passive losses are generally allowed in full in the year you sell your entire interest in the rental (Publication 925). They then offset other income, not only the rental gain.

Three conditions apply:

• You dispose of your entire interest in the passive activity. If you grouped several rentals as one activity, selling one generally does not release the activity's losses unless you can prove the losses tied to the part sold (Publication 925).
• The transaction recognizes all realized gain or loss, so a like-kind exchange that defers gain does not release the losses.
• The buyer is not related to you.

In an installment sale, the losses are released in proportion to the gain recognized each year (Publication 925). A capital loss on the sale first offsets capital gains. Any net capital loss then reduces other income by up to $3,000 a year ($1,500 if married filing separately), with the rest carried forward.

What if I sell the rental at a loss?

A loss on rental real estate held more than a year is generally a section 1231 loss, reported in Part I of Form 4797. A net section 1231 loss is an ordinary loss (Publication 544).

• Depreciation lowers basis, so a sale below what you paid can still produce a taxable gain.
• If the rental is not a trade or business, the loss is a capital loss. It offsets capital gains, then up to $3,000 of other income a year ($1,500 if married filing separately) (IRS Topic 409).
• Form 8582 comes first. It shows how much passive loss is allowed before the loss goes on Form 4797 (Form 4797 instructions). Selling your entire interest in the passive activity to an unrelated buyer in a fully taxable sale releases suspended passive losses (above).
• A former home turned rental: the deductible loss starts from the lower of adjusted basis or fair market value on the day it became a rental, adjusted for later improvements and depreciation (Publication 544).
• A loss on a sale to a related person is not deductible (Publication 544).

Example

All amounts are in US dollars and are illustrative. They ignore state tax and the net investment income tax.

Sale with depreciation taken

A landlord bought a rental for US$300,000: US$60,000 for the land and US$240,000 for the building. Depreciation taken totals US$60,000. The property sells for US$450,000 with US$27,000 of selling costs. Assume the building holds at least US$60,000 of the gain.

The US$60,000 layer is taxed at a maximum of 25%, or up to US$15,000. The US$123,000 is taxed at 0%, 15% or 20%, depending on income.

Depreciation never taken

A landlord rented a house for 8 years and never claimed depreciation on the US$240,000 building. About US$8,700 a year was allowable (US$240,000 over 27.5 years), roughly US$70,000 in total. The building's adjusted basis is US$170,000, not US$240,000. If the building's share of the net sale price is US$300,000, the gain is US$130,000, and US$70,000 of it is in the depreciation layer, as if the deduction had been taken.

Owner-financed sale

A landlord sells for US$400,000: US$100,000 down and a US$300,000 note paid over 10 years. Depreciation taken is US$50,000 and the total gain is US$200,000, ignoring selling costs and interest. Half of each dollar of principal received is gain.

• Year of sale: the US$100,000 down payment carries US$50,000 of gain. The instructions generally treat all of it as unrecaptured section 1250 gain, so the whole depreciation layer is reported in the year of sale.
• Later years: the other US$150,000 of gain arrives with the note payments, as long-term capital gain.
• Appliances: if the appliances have no basis left and are sold separately for US$5,000, on top of the US$400,000, that US$5,000 is ordinary income in the year of sale, even if the buyer has not yet paid it. The real estate figures above are unchanged.

Different for you?

• The property is under contract, financed or being exchanged, or the depreciation history is unclear: the basis, the recapture figure, the forms and the tax to set aside depend on the file, and an exchange is arranged before closing. Get individual tax help while those choices are still open.
• You never took depreciation: see missed depreciation on a rental.
• Your rental books are behind, or the closing statement and the books do not reconcile: basis and depreciation cannot be proved without them. See catching up on rental books and rental closing statements in the books, and get bookkeeping help.
• The rental was once your home, or you moved into it before selling: the home-sale exclusion cannot shelter the part of the gain equal to depreciation taken after May 6, 1997 (Publication 523). The exclusion and rental years are in the home-sale exclusion guide.
• You inherited or were given the rental: an inherited rental's basis is generally its fair market value at the date of death (or the alternate valuation date), so the earlier owner's depreciation does not carry to you. A gifted rental is different: you generally keep the giver's basis, which already reflects their depreciation (Publication 551). Get individual tax help before you sell.
• The rental is held in an LLC or partnership: see rental property in an LLC.
• The owner is not a US citizen or resident: withholding on the sale is covered in nonresident landlords.
• You live in Canada or another country, or the sale is also taxed there: each country has its own rules for the gain, and the credits have to line up. See exchanging a US rental and get cross-border tax help.
• Past returns are missing: see catching up on unfiled returns.
• The rental is in Canada: see selling a rental property in Canada.
• You want the wider rental picture: see rental property taxes. A state can tax the gain differently, so check your state's revenue department too.