1031 Exchange Depreciation Recapture: Unrecaptured §1250 Gain Explained

The number that catches most rental owners off guard is not the sale price. It is the gain. They bought a building for $350,000, they are selling for $800,000, and they assume the taxable gain is the difference. Then their CPA shows them a much bigger number, and the reason is depreciation.

Every year you owned that rental, you took a depreciation deduction that lowered your taxable income. That was a real benefit while you held it. But depreciation does not come free. It lowers your basis in the property, and a lower basis means a larger gain when you sell. A 1031 exchange can defer that gain, including the part tied to depreciation, but it does not erase it. The recapture is still there, waiting for the day you finally cash out.

Adjusted basis versus original cost

Your original cost basis is roughly what you paid, your purchase price plus closing costs you capitalized. That number does not stay fixed. Over time you adjust it: capital improvements push it up, and depreciation pushes it down.

The formula is simple. Adjusted basis equals original cost plus improvements minus accumulated depreciation. If you paid $350,000 and claimed $75,000 in depreciation over the years, with no improvements, your adjusted basis is $275,000. The depreciation lowered your basis by exactly the amount you deducted.

This matters because gain is measured against adjusted basis, not original cost. You can see how basis flows into the gain math in the 1031 exchange calculator, which separates the depreciation portion from the rest of the gain automatically.

Why depreciation increases your gain

Here is the mechanics on a real set of numbers. Sale price $800,000, exchange costs $48,000, original basis $350,000, depreciation claimed $75,000.

Start with the net amount realized: $800,000 minus $48,000 in costs equals $752,000. Subtract your adjusted basis of $275,000, and the realized gain is $477,000.

Notice what happened. If your basis had stayed at the original $350,000, your gain would have been $402,000. Because depreciation cut your basis by $75,000, your gain went up by that same $75,000, landing at $477,000. The deductions you took along the way are now part of the gain. That is recapture, and it is the price of having lowered your taxable income year after year.

Ordinary recapture versus unrecaptured Section 1250 gain

People hear “recapture” and assume it gets taxed as ordinary income at their top rate. For most real estate, that is wrong, and the distinction is worth real money.

There are two flavors. Ordinary depreciation recapture (Section 1245, and the Section 1250 piece tied to accelerated depreciation) is taxed as ordinary income. This mostly hits equipment, and it hits real property only when someone claimed accelerated depreciation in the past. For long-held real property depreciated on the straight-line method, which covers nearly every residential and commercial rental held under modern rules, there is no ordinary recapture on the building itself.

Instead, the depreciation portion becomes unrecaptured Section 1250 gain. This is a long-term capital gain, not ordinary income, and it carries its own ceiling: a maximum federal rate of 25%. So in the example, of the $477,000 realized gain, the first $75,000 (matching the depreciation taken) is unrecaptured Section 1250 gain. The remaining $402,000 is regular long-term capital gain, taxed at standard capital gains rates.

Why the rate can be below 25% but never above it

The 25% figure is a cap, not a flat rate, and that surprises people in both directions.

Unrecaptured Section 1250 gain is taxed at your ordinary marginal rate, but the rate is capped at 25%. If your ordinary brackets would push this income above 25%, the cap holds it down. If your ordinary brackets sit below 25%, you pay the lower rate. So a high earner pays the full 25%, and a lower-bracket investor can pay less than 25% on part of it. The one thing that cannot happen is paying more than 25%.

In the main example, the taxpayer is a single filer with $250,000 of other taxable income. Their ordinary income already fills the brackets above the 25%-equivalent level, so the entire $75,000 hits the cap. The tax on it is $18,750, which is exactly 25% of $75,000.

Now change the facts. Suppose only $50,000 of unrecaptured Section 1250 gain is recognized, and it stacks on $180,000 of ordinary income for a single filer. The tax is not a flat $12,500. It is $12,282.25. Here is why: $21,775 of that gain falls in the 24% ordinary range and is taxed at 24% ($5,226.00), while the remaining $28,225 reaches the 25% cap ($7,056.25). Add those and you get $12,282.25. That is the proof. Part of the gain is taxed below 25% because the investor’s ordinary rate there is only 24%.

What happens in a clean full-deferral exchange

A clean 1031 exchange, where you reinvest all the proceeds and take no cash out, defers the entire gain. Not part of it. All of it, including the unrecaptured Section 1250 portion.

In the example, you reinvest into a $950,000 replacement property and receive no boot. Your $477,000 realized gain is fully deferred. You pay $0 in federal tax today. The $75,000 of Section 1250 gain rides along with the rest into the new property’s basis.

It helps to see what you deferred. If you had sold outright instead of exchanging, the federal tax on that sale would have been:

Unrecaptured Section 1250 tax: $18,750
Capital gains tax: $65,625
Net investment income tax: $18,126
Total: $102,501

A clean 1031 defers all $102,501. To be precise about what “defer” means: the tax is not gone. It is pushed forward. The deferred gain is baked into the lower basis of your replacement property, and it surfaces when you eventually sell that property in a taxable transaction. The calculator’s “High-Gain Sale + NIIT” scenario shows this full breakdown, including how the net investment income tax stacks on top of the capital gains and Section 1250 pieces.

What happens when you receive boot

A partial exchange, where you pull out cash or reduce your debt, creates boot. Boot is the non-like-kind value you receive, and it is taxable now, up to the amount of your realized gain.

The character of that recognized boot follows an ordering rule, and the ordering favors the IRS. Recognized gain is treated as unrecaptured Section 1250 gain first, until the entire Section 1250 amount is used up, and only then as regular long-term capital gain. So the more expensive 25%-capped dollars come out first when you take boot. You do not get to claim the boot is “just” lower-rate capital gain while leaving the recapture safely deferred.

Take the lower-income example again. If that $50,000 of unrecaptured Section 1250 gain is the recognized boot, the tax on it is the $12,282.25 computed above, plus $1,140 of net investment income tax, for a total of $13,422 of tax on the boot. The rest of the gain stays deferred in the replacement property. The lesson is plain: if you want to defer the recapture, do not take boot. Every dollar of boot eats into the Section 1250 layer first.

How this gets reported

A 1031 exchange is reported on Form 8824, Like-Kind Exchanges, which is where you compute realized gain, recognized gain (if any boot was received), and the basis of your replacement property. The deferred recapture is not reported as income now, but it is tracked through that carryover basis. When you sell the replacement property without another exchange, the unrecaptured Section 1250 gain from every property in the chain comes due at once.

That is the real shape of depreciation recapture in a 1031 exchange. The exchange is a deferral tool, not an eraser. You keep the cash you would have paid in tax and put it to work in a bigger property, but the recapture clock is still running underneath. Plan your eventual exit, or your heirs’ step-up, with that in mind.

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Frequently Asked Questions

Does a 1031 exchange eliminate depreciation recapture?

No. It defers it. A clean exchange with no boot pushes the entire gain forward, including the unrecaptured Section 1250 portion, into the basis of your replacement property. The recapture is not erased. It surfaces when you eventually sell that property in a taxable transaction without another exchange.

Is unrecaptured Section 1250 gain always taxed at 25%?

No. The 25% figure is a maximum, not a flat rate. The gain is taxed at your ordinary marginal rate, capped at 25%. A high earner whose ordinary income already exceeds the cap pays the full 25%, but a lower-bracket investor can pay less on part of the gain. In one example, part of the gain is taxed at 24% because the investor’s ordinary rate there is below the cap.

What is adjusted basis?

Adjusted basis is your original cost plus capital improvements minus accumulated depreciation. If you paid $350,000 and claimed $75,000 of depreciation with no improvements, your adjusted basis is $275,000. Gain is measured against adjusted basis, not original cost, which is why depreciation increases your taxable gain.

What happens to the recapture if I take boot?

Recognized boot is taxed under a character ordering rule. It is treated as unrecaptured Section 1250 gain first, up to the full Section 1250 amount, and only then as regular long-term capital gain. So the 25%-capped dollars come out first. If you want to keep the recapture deferred, do not take boot.

Where is a 1031 exchange reported?

On Form 8824, Like-Kind Exchanges. That form computes your realized gain, any recognized gain from boot, and the carryover basis of your replacement property. The deferred recapture is tracked through that basis rather than reported as income in the year of the exchange.