The Year Before a Sale: Tax Prep for Landlords That Makes an Exchange Cleaner

Fix the depreciation record first, because unclaimed depreciation reduces your basis anyway

Section 1016(a)(2) reduces basis by depreciation allowed, but not less than the amount allowable, and IRS Publication 527 says the same in plain terms: your depreciation includes any you were allowed to claim, even if you did not. A landlord who skipped it has a lower basis and the same recapture exposure as one who claimed it, without the deductions.

Rev. Proc. 2025-23 lets you change from that impermissible method to a permissible one as an automatic change, designated change number 7 in section 6.01. It applies to property for which the wrong method was used in at least two taxable years before the year of change and that you own at the beginning of the year of change. The Form 3115 instructions give a one-year adjustment period for a negative section 481(a) adjustment, so the missed depreciation is deducted in one return.

Hypothetical: a building portion of $275,000, never depreciated for six years, has roughly $10,000 a year of straight-line depreciation allowable, about $60,000 in total. Filing Form 3115 the year before the sale puts that deduction on the return, though the passive activity rules can limit when you use it. Our catch-up depreciation before a sale page covers the filing itself, and recapture on depreciation you never claimed explains why skipping it costs you.

Rebuild the basis file now, because an exchange carries it into the next property

IRS Publication 551 tells owners to keep accurate records of everything that affects basis. Section 1016(a)(1) adds capital improvements; depreciation and casualty losses subtract. For a rental, that means the closing statement from the purchase, invoices for roofs, additions and systems, and the land and building split used for depreciation.

If the property came from an earlier exchange, its basis is the old property's basis carried forward under section 1031(d), so you need that exchange's Form 8824 too. The Form 8824 instructions use the basis of the property given up to figure the basis of what you receive, which makes a missing record from fifteen years ago today's problem.

Do this before you price the sale. The gain you are deferring, the boot you can afford and the depreciation you will inherit on the replacement all start from this number.

Count your suspended passive losses, because an exchange keeps them locked up

IRS Publication 925 allows prior-year unallowed passive losses in full when you dispose of your entire interest in the activity in a transaction where all realized gain or loss is recognized, to a buyer who is not related to you. Section 469(g) is the statute behind it.

A 1031 exchange does not recognize all the gain, so the losses stay suspended and follow you. Find the carryover on your most recent Form 8582. A large carryover against a modest gain can make a taxable sale cheaper than it looks; suspended passive losses and a 1031 runs that comparison, and the passive loss rules for landlords explain where the carryover came from.

The losses are not lost if you exchange. They stay attached to you and are released later, when you finally dispose of your entire interest in a fully taxable sale, so the question is timing, not forfeiture. Price both paths with your preparer before you sign a listing agreement.

Settle who holds title a year out, because the seller must also be the buyer

The taxpayer who sells must be the taxpayer who buys. Moving the property into a single-member LLC that is disregarded for tax purposes leaves you as the owner; Rev. Proc. 2002-22 treats title held through a disregarded entity as held directly. Moving it into a multi-member LLC creates a partnership, and the partnership becomes the seller. See same-taxpayer rules before any deed is recorded.

If co-owners will go separate ways, the restructuring belongs in this year too, well before a listing; partners who want different replacement properties explains why timing matters for the held-for-investment test.

Check the lender too. A transfer into an LLC can trip a due-on-transfer clause, and the deed, the insurance and the leases should all name the same owner by the time a buyer's title company starts work. Fixing a mismatched vesting during the 45-day identification window is the version of this job nobody wants.

Plan the cash side: estimated tax for any boot and a team that has seen the numbers

If you expect to take some cash or debt relief as boot, that gain is taxed in the year of sale. IRS Publication 505 lets you avoid an underpayment penalty by paying 110% of the prior year's tax, instead of 100%, when the prior year's adjusted gross income exceeded $150,000, or $75,000 if married filing separately.

Hand your CPA a one-page file before the listing goes live: adjusted basis, depreciation taken and allowable, any cost segregation components that will be recaptured as ordinary income, suspended losses, the titleholder and the expected boot. Coordinating your 1031 advisor team covers who needs what and when. Run your own numbers with your CPA.

• Twelve months out: depreciation review, Form 3115 decision, basis file started.
• Nine months out: suspended loss figure, title and entity changes recorded.
• Six months out: CPA estimate of gain, recapture and any boot; replacement strategy chosen.
• Listing: exchange cooperation clause in the contract and an intermediary lined up before closing.