Depreciation recapture when you sell a short-term rental

By Max Medvedev · 6 Aug 2026

The short version: three layers, three ceilings

At sale the depreciation comes back. Whatever you took on the 5- and 7-year cost-seg property returns as ordinary income under §1245, at rates up to 37%. The building's straight-line depreciation becomes unrecaptured §1250 gain, capped at 25%. Anything above that is long-term capital gain. Holding longer erases none of it.

The layers, and where each rate ceiling comes from

The order matters more than the labels. A first-year cost-seg deduction is weighted toward the §1245 bucket — the one that comes back at ordinary rates. So a study is not a pure discount; it is a rate-and-timing trade, and what a cost segregation study buys has to be read against this table rather than on its own.

Never cap §1245 at 25%. That single error makes an exit model look far cheaper than it is, and it is a common one.

The 15-year buckets are §1250, not §1245

Land improvements — the driveway, the fence, the pool — and qualified improvement property carry 15-year lives, which makes them feel like the personal-property bucket. They are not. Both are §1250 property, so they are not swept into the §1245 ordinary-income layer. A summary that calls the whole cost-seg carve-out "§1245" overstates the exit bill, sometimes badly.

Only the 5- and 7-year personal property — appliances, furniture, carpet, window treatments, decorative lighting — is §1245.

Recapture is owed on depreciation you never claimed

This is the part that surprises owners who skipped depreciation on purpose, usually to avoid "the tax at the end."

IRC §1016(a)(2) adjusts basis for depreciation allowed or allowable — the amount you actually deducted, but not less than the amount you could have. A year of depreciation you never claimed still comes out of basis. Basis is lower, gain is larger, and the tax arrives exactly as if the deduction had been taken. Skipping it buys nothing and costs the deduction.

The repair is not an amended return. Form 3115, automatic consent DCN 7, filed with the current-year return, claims the cumulative missed depreciation as a one-time §481(a) catch-up — the same mechanism that lets a prior-year purchase run a look-back cost-segregation study. The bonus rate stays fixed to the original placed-in-service year.

Recapture cannot exceed the gain — but a study makes gain arrive sooner

§1245 turns the lesser of the depreciation taken or the gain realized on that asset into ordinary income. Sell for less than adjusted basis and there is nothing to recapture.

The catch is what a study does to adjusted basis. Expensing $250,000 in year one drops basis by $250,000 immediately, so a sale that looks like breaking even against the purchase price can still produce a large gain. The recapture bill tracks the depreciation you took, not the appreciation you earned, which is why an exit model built on "will the property go up?" answers the wrong question.

The 3.8% that material participation removes

The Net Investment Income Tax is a 3.8% surtax under §1411 once modified AGI exceeds $200,000 single / $250,000 married filing jointly — the band most owners running this strategy are already in.

Gain on the sale of a rental is investment income and carries the 3.8% unless the property was a non-passive trade or business to the seller, meaning the owner materially participated (§1411(c)(1)(A)(iii)). That moves the top rate on unrecaptured §1250 gain from 28.8% for a passive owner to 25% for one who participated.

So the hours log pays twice. It is what makes the first-year loss non-passive, and years later it is what keeps 3.8% off the exit. Passing the seven-day average-stay test alone does neither — that only removes the automatic passive label, and material participation is a separate requirement under Reg. §1.469-5T(a). The record that carries it is described in how to prove your short-term rental hours.

§1031 defers the building, not the furniture

A like-kind exchange defers gain on the real property. Since TCJA it no longer covers personal property, so the §1245 slice a cost-segregation study carved out cannot ride along — its recapture triggers inside an otherwise-deferred swap. The more aggressive the study, the larger the piece that cannot be exchanged. Worth modeling before the study, not after the buyer is under contract.

Suspended passive losses release at the sale

If the losses were suspended — no material participation, so they piled up under §469 — a fully taxable disposition to an unrelated party releases them in full under §469(g). That release lands in the same year as the recapture and often absorbs a large part of it.

One trap sits underneath: if the property was grouped with others under Reg. §1.469-4, selling one of them is not a disposition of substantially all of the activity, and the suspended losses stay suspended.

"How long do I have to hold it?"

There is no holding period that erases recapture, which is what the question is usually hoping for. §1245 applies in year two and in year twenty.

What does change with time is the arithmetic: a deduction taken at today's marginal rate against recapture at the rate in the year of sale, plus the years of deferral in between, plus whether you still materially participate when you sell. That is a model with your own rates in it, not a number of years — and the mechanics feeding it are in the depreciation guide.

Model your own exit before you need it

Run the purchase, the study, and a sale year through the estimator — it splits the recapture between §1245 and §1250, applies the NIIT swing, and cites the rule behind each figure.