Is boot taxed as depreciation recapture or capital gain first?

The IRS's own Form 8824 example puts ordinary income at the front of the queue

The instructions to Form 8824 work an exchange in which Taylor recognizes $40,000 of gain. Taylor 'enters $35,000 on line 21 as ordinary income under the section 1245(b)(4) recapture rules', then 'subtracts line 21 from line 20 and enters $5,000 on line 22'. The ordinary layer is filled first and the capital layer gets the remainder.

That sequence is built into the form. Line 20 measures the gain you recognize, line 21 pulls out the ordinary recapture, line 22 is what is left, line 23 adds them back, and line 24 is the gain you deferred. Nothing about it is elective.

So the first question to ask about your own boot is not what rate applies but how much of your depreciation sits in §1245 assets rather than in the building shell.

§1245(b)(4) lets the ordinary layer run past the cash you kept

Section 1245(b)(4) limits the ordinary income to 'the amount of gain recognized on such disposition (determined without regard to this section), plus the fair market value of property acquired which is not section 1245 property'. In a real estate exchange the replacement is almost always §1250 property, so the cap is roughly the whole purchase price and the limit never bites.

The Form 8824 instructions make the consequence explicit in a variant of the same example: with $50,000 of §1245 recapture against a $40,000 recognized gain, Taylor enters $50,000 on line 21, $0 on line 22, and reports $50,000. You kept $40,000 and were taxed on $50,000.

That is also why recapture can appear in an exchange where you took no cash at all, a result worked through in can I owe recapture with no cash.

The 25% slot fills before any 15% or 20% gain, and the regulation says so

Straight-line depreciation on a building creates no §1250 ordinary recapture, but it does create unrecaptured §1250 gain, which Publication 544 describes as 'the part of any long-term capital gain on section 1250 property (real property) that is due to depreciation' and which 'cannot be more than the net section 1231 gain or include any gain otherwise treated as ordinary income'.

It is taxed at a maximum 25%, one of the five maximum capital gains rates Pub. 544 lists for individuals, and the Schedule D Tax Worksheet computes it on its own line at 0.25. Reg. §1.453-12(a) states the ordering directly: 'the unrecaptured section 1250 gain is taken into account before the adjusted net capital gain'.

The Schedule D instructions say the same in the worksheet steps for a deferred payout: 'the amount of capital gain on each installment payment is treated as unrecaptured section 1250 gain until the total unrecaptured section 1250 gain ... has been used in full'. Partial deferral does not let you cherry-pick the cheap layer.

Worked example: $120,000 of boot against $150,000 of straight-line depreciation

Assume a rental bought for $600,000, depreciated straight line to a $450,000 adjusted basis after $150,000 of deductions, sold for $1,200,000 with no mortgage and no cost segregation. You direct the intermediary to release $120,000 to you and buy a replacement with the rest.

Realized gain is $750,000 and recognized gain is $120,000. No §1245 property exists, so line 21 is zero and the whole $120,000 lands on line 22. Because $150,000 of unrecaptured §1250 gain is waiting and only $120,000 is recognized, every dollar of the boot fills the 25% slot and none of it reaches 15% or 20%.

Federal cost is up to $30,000 at 25% plus $4,560 of net investment income tax at 3.8%, about $34,560 before state tax. The remaining $630,000 of gain, including the last $30,000 of the depreciation layer, stays deferred in the replacement's basis. Figures are round and hypothetical.

• Boot $120,000; unrecaptured §1250 gain available $150,000; amount taxed at 25%: $120,000.
• Amount reaching the 15% or 20% rate: zero, because the depreciation layer was not exhausted.
• Deferred gain carried into the replacement's basis: $630,000 (how basis is figured).

Cost segregation changes the character of the same $120,000, not the amount

Rerun the example with a cost segregation study that had carved $90,000 of five- and fifteen-year §1245 components out of the building and written them to zero. Line 21 now takes $90,000 as ordinary income at your marginal rate, and only $30,000 drops to line 22 for the 25% slot.

If the §1245 depreciation had been $150,000 instead, line 21 would take the full $150,000, line 22 would be zero, and you would report $150,000 of ordinary income against $120,000 of cash. A study that saved tax at 32% or 37% while you owned the building can cost the same rate on the way out.

Owners weighing a study on the replacement should read bonus depreciation and cost segregation on a replacement property with this ordering in mind.

• No §1245 components: $120,000 at 25% plus 3.8%.
• $90,000 of §1245 components: $90,000 ordinary plus $30,000 at 25%, all plus 3.8%.
• $150,000 of §1245 components: $150,000 ordinary, recognized gain exceeds the cash by $30,000.

Which year each layer lands in, and the one layer that never moves

Debt relief is delivered at the relinquished closing, so mortgage boot belongs to the year of sale. Cash the intermediary still holds is different: Reg. §1.1031(k)-1(j)(2) disregards the intermediary in deciding whether you have been paid, and its examples let a taxpayer who is paid out in the following year report that gain in the later year under the installment method (the straddle).

The exception is the one that matters here. Section 453(i) provides that 'any recapture income shall be recognized in the year of the disposition, and any gain in excess of the recapture income shall be taken into account under the installment method'. Your §1245 layer is due for the sale year whatever the intermediary does with the cash.

On the forms, line 21 carries to Form 4797 and line 22 to Form 4797 line 5 or 16 or to Schedule D; the routing is mapped in where boot and recapture go on Form 4797 and Schedule D. Confirm your own layering with your CPA or attorney before you tell the intermediary how much to release, because the ordering decides the rate, not the amount.