Depreciation Recapture on a Short-Term Rental

What depreciation recapture is

Depreciation gives you a deduction every year for wear on the building and its parts. It also cuts your basis in the property by the same amount. Basis is what you subtract from the sale price to work out your gain. So every dollar of depreciation you take is a dollar of extra gain waiting at the sale.

When you sell, the IRS separates that gain into pieces and taxes them at different rates. The piece that matches the depreciation you took is called recapture, and it never gets the friendly long-term capital gain rate.

One detail catches people. The rules use depreciation "allowed or allowable." If you owned a rental and never claimed depreciation, you still lose the basis. Skipping it does not avoid the bill.

Section 1250: the building, at up to 25 percent

Residential rental property is Section 1250 property. Under MACRS it is depreciated straight line over 27.5 years, so there is no depreciation above straight line on the shell and no ordinary recapture under Section 1250 itself.

Instead the straight-line depreciation comes back as unrecaptured Section 1250 gain. It is taxed at your ordinary rate, but the rate is capped at 25 percent. If you are in the 12 percent bracket it is taxed at 12 percent. If you are at 37 percent it is taxed at 25 percent.

This is the mildest piece of the bill, and it is the piece you would have had even without a cost segregation study.

Section 1245: the cost segregation components, at ordinary rates

A cost segregation study is what makes the first-year deduction large. It also creates the expensive part of the recapture.

The study moves parts of the building into short recovery classes. Appliances, carpet, cabinets, window coverings, specialty electrical and furniture usually land in five or seven year classes. Those are Section 1245 property. When you sell, all the depreciation taken on them is recaptured as ordinary income, up to the amount of gain. At a 37 percent bracket that is a 37 percent rate, not 25.

Land improvements such as driveways, fencing, and landscaping go into a fifteen year class. Those are generally Section 1250 property, but bonus depreciation on them is depreciation far above straight line. That excess over straight line is recaptured as ordinary income under Section 1250(b). Only the straight-line part gets the 25 percent cap.

How the split falls depends on how your study classified each asset. Ask the firm that wrote the study to give you the class life for every line before you sell, not after.

A worked example: year one against the day you sell

These are assumptions. Every one of them changes the answer.

The assumptions

Depreciation taken over six years

The gain on sale

How the gain is taxed

What it nets out to

Of the $67,229, the part caused by depreciation is $57,569. The $9,660 of long-term gain would have been there anyway from the price going up.

So the strategy did not create $64,000 of savings. It created about $6,000 of permanent difference and six years of free use of the money. That is still a good trade for most people, but it is not the number you see on social media.

Change one assumption and it flips

Run it again with the ordinary rate at 37 percent in the sale year instead of 32 percent, for example because the sale year pushes you up a bracket.

Almost all of the benefit is gone. The gain in the sale year is part of what pushed the rate up, which is exactly how this happens in real life.

Four ways to manage the bill

1. Do not sell

Recapture is only triggered by a sale or another taxable disposition. Refinancing is not a sale. Pulling cash out with a loan is not a sale. A long hold turns a deferral into a very long deferral, and the rental keeps producing deductions the whole time.

2. Use a 1031 exchange

A like-kind exchange under Section 1031 rolls the gain and the recapture into the next property by carrying over your low basis. It needs a qualified intermediary in place before closing, a replacement identified within 45 days, and the purchase closed within 180 days.

Two catches worth knowing. Since 2018 Section 1031 covers real property only, so the personal property that a cost segregation study carved out may not qualify and can trigger Section 1245 recapture at the exchange. And any boot you take, cash or debt relief, is taxed, with recapture coming out first.

3. Hold until death

Under Section 1014 the heirs take the property at its value on the date of death. The whole depreciation history is erased along with the built-in gain. This is the reason many owners plan never to sell. It is real under current law, and it is also the part of a plan most exposed to a future law change.

4. Offset the income in the sale year

Ordinary recapture is ordinary income, so ordinary losses offset it. Buying another property in the same year and running a cost segregation study on it is the common move. Suspended passive losses on the property you sell are released in full on a taxable sale to an unrelated party. Charitable bunching, a large retirement plan contribution, or a business loss in the same year all work on the same income.

What does not work well: stock capital losses only offset the capital gain piece, plus $3,000 a year against ordinary income. And an installment sale does not spread the Section 1245 recapture. Section 453(i) makes all of it taxable in the year of sale even if the cash comes in over ten years.

When the loophole is still worth it

It is worth it when the numbers below hold.

• Your marginal rate today is high and you expect it to be lower when you sell.
• You plan to hold for five years or more, so the deferral has time to be worth something.
• You intend to exchange under Section 1031 or hold for life.
• The cash from the year-one refund goes into something that earns a return, not into a car.
• The property is large enough that a study fee of $5,000 to $15,000 is small next to the deduction.

When it is not

• You plan to sell within two or three years. The deferral is too short to pay for the study.
• Your income is rising, so the sale year rate is likely to be higher than today's.
• The property is under about $400,000 and the short-life share is small.
• You cannot meet a material participation test, so the loss is suspended anyway and the study buys you nothing this year.
• You are buying only for the deduction. A weak property with a strong tax result still loses money.

If you are still deciding whether you can clear the tests at all, start with the short-term rental loophole guide and the REPS versus STR loophole comparison. Run your own purchase numbers in the short-term rental purchase analysis calculator and the rental property cash flow calculator before you commit to anything.