Selling a Fully Depreciated Rental: Sale Math When Recapture Is Bigger Than the Gain

Once the building is fully depreciated, your basis is the land, and the gain can be smaller than the depreciation you took

Residential rental property is depreciated over 27.5 years and nonresidential property over 39 years, or 31.5 years if it was placed in service before May 13, 1993, according to Publication 946. A duplex placed in service in 1990 or an office building bought in 1989 has written its entire building cost off. What is left in your adjusted basis is the land, plus any improvements still on a schedule.

That is why owners of these properties are surprised by the size of the gain. The amount realized is measured against land cost alone, and the depreciation you claimed over three decades sits inside the gain. Publication 544 states that basis is reduced by depreciation allowed or allowable, so years you skipped still count.

The gain is smaller than the depreciation whenever the sale price, after costs, is below what you originally paid for land and building together. That happens in soft markets and with older commercial buildings, and when it does, the gain is entirely the depreciation layer.

The 25% layer covers the whole gain because unrecaptured section 1250 gain is capped at the gain, not at the depreciation

Section 1(h)(6) defines unrecaptured section 1250 gain as the long-term gain that would be ordinary income if all depreciation were treated as recapture. Because it can only be carved out of gain you actually have, it equals the smaller of depreciation taken or the gain. Section 1(h)(1)(E) taxes that layer at your ordinary rate with a 25% ceiling.

When depreciation exceeds the gain, the 15% and 20% rates never apply. Every dollar falls in the 25% slot, and if your ordinary bracket is 32% or higher, the full 25% applies. A seller in the 22% or 24% bracket pays those rates on the part of the layer that fits in them.

Ordinary-income recapture is a separate question. Publication 544 explains that for section 1250 property held more than a year, only depreciation above straight line is recaptured as ordinary income, and buildings placed in service after 1986 are depreciated straight line. Appliances, carpets and other section 1245 items are different: their depreciation is recaptured as ordinary income, which section 1245 recapture on real estate covers.

Worked model: a 1989 building sold below its cost still produces a $351,520 tax bill

Hypothetical: a couple filing jointly bought a small office building in 1989 for $1,500,000, $300,000 for the land and $1,200,000 for the building. On a 31.5-year schedule it was fully depreciated by about 2020. In 2026 they sell for $1,400,000 and pay $60,000 of selling costs, so the amount realized is $1,340,000. Their other taxable income is $450,000, and for simplicity their MAGI equals taxable income.

Adjusted basis is $300,000, so the gain is $1,040,000. Depreciation of $1,200,000 is larger than the gain, so all $1,040,000 is unrecaptured section 1250 gain. At 25%, that is $260,000. Net investment income tax adds 3.8% of $1,040,000, or $39,520. A hypothetical 5% state tax adds $52,000, for $351,520 in total.

If the same $1,040,000 had been ordinary long-term gain, the 2026 breakpoints in Rev. Proc. 2025-32 would put $163,700 of it at 15% and the rest at 20%, or $199,815 of federal capital gains tax. The depreciation layer costs these sellers $60,185 more, on a sale for $100,000 less than they paid. Run your own numbers with your CPA.

• Amount realized: $1,400,000 price less $60,000 costs = $1,340,000.
• Adjusted basis: $1,500,000 cost less $1,200,000 depreciation = $300,000.
• Gain $1,040,000, all of it in the 25% layer: $260,000.
• NIIT at 3.8%: $39,520. Hypothetical 5% state: $52,000.
• Total $351,520, which is 26.2% of the amount realized and 33.8% of the gain.

An exchange defers the full bill, but the replacement starts with the same thin basis

Under section 1031, buying replacement real estate of at least $1,340,000 with all the cash defers the $1,040,000 gain. Section 1031(d) gives the replacement the old $300,000 basis, increased by any cash you add or debt you take on.

That carried-over basis has a quirk worth modelling. Reg. section 1.168(i)-6 depreciates exchanged basis over the old building's remaining schedule, but it limits exchanged basis to the old building's adjusted depreciable basis, which here is zero. Whatever basis is allocated to the new building is excess basis, treated as placed in service in the year of replacement on a fresh 27.5- or 39-year schedule. Depreciating the replacement works that split through.

A fully depreciated building shelters none of its rent, so its income is fully taxable each year. Adding new debt in the exchange raises basis and restarts deductions, which is one reason owners of these properties trade up rather than out.

Choosing among selling, exchanging and holding when the basis is the land

Selling makes sense when the cash need is real and the bill is acceptable, or when an older owner's other income is low enough that part of the layer falls in the 22% or 24% brackets. Exchanging makes sense when you want to keep the capital invested and can use the reset in depreciation.

Holding until death is the third path. Section 1014 gives heirs a basis equal to value at death, so the deferred layers are never taxed to them; exchanging versus holding for the step-up compares the two. Owners who want to stop managing property but keep the deferral often exchange into fractional interests such as a Delaware statutory trust, which Rev. Rul. 2004-86 allows as like-kind replacement property.

If the property carries a large mortgage, check that sale proceeds will cover both the payoff and the tax before you list; 1031 strategies for highly leveraged owners covers that case. State treatment varies, so check your state on the state rules pages.