Selling U.S. Rental Property: Depreciation Recapture Explained

A foreign owner sells a U.S. rental property, subtracts what was paid from what it sold for, and expects a modest tax on a modest gain. The number that actually shows up is larger, sometimes considerably larger, and the reason is depreciation. Every dollar of depreciation claimed while the property was rented reduces its basis, which increases the gain at sale, and a portion of that gain is then taxed at its own rate under the unrecaptured section 1250 rules. The part that catches owners hardest is that this basis reduction happens whether or not depreciation was ever actually claimed on a return.

How depreciation and basis interact

While a rental property is held, depreciation under IRC §168 is deducted each year against rental income, using a 27.5-year straight-line schedule for residential property or a 39-year schedule for nonresidential property. Each year's deduction also reduces the property's adjusted basis under IRC §1016(a)(2). A $300,000 building depreciated over 27.5 years generates roughly $10,900 of depreciation a year, and after ten years of ownership the building's basis has fallen by roughly $109,000, independent of anything happening to the property's market value.

Gain on sale is measured as the amount realized minus adjusted basis, not minus original purchase price. Ten years of depreciation on the example above means the basis used to compute gain is $109,000 lower than it would be without that depreciation, which means the taxable gain is $109,000 higher for exactly the same sale price. The deductions taken during ownership are not free; they are borrowed against the gain that gets taxed at the end.

What "allowed or allowable" means, and why it is unforgiving

This is the single most important mechanic on this page. IRC §1016(a)(2) reduces basis by depreciation "allowed" or, if greater, depreciation "allowable." Allowable means the depreciation the owner was entitled to claim under the applicable method, whether or not it was ever actually claimed on a filed return.

An owner who never filed a U.S. return for the rental years, or who filed but failed to claim depreciation, does not avoid this reduction. The basis is treated as though the depreciation had been taken, the deduction is lost for the years it should have applied, and the reduced basis still applies at sale. This produces the worst combination available: no benefit during the years the property was rented, and the full basis reduction, with its full effect on the gain, at the moment of sale. Owners who never realized they needed to file U.S. returns on their rental income arrive at this point routinely, and it is rarely a pleasant discovery mid-transaction.

Unrecaptured section 1250 gain: the rate that applies to the depreciation portion

Real property placed in service after 1986 is depreciated on a straight-line basis, which means the ordinary recapture rule in IRC §1250, aimed at the excess of accelerated depreciation over straight-line, generally produces little or nothing to recapture as ordinary income for a typical post-1986 rental. That does not mean the depreciation escapes special treatment. IRC §1(h)(1)(E) and §1(h)(6) create a separate category, unrecaptured section 1250 gain, which is the portion of the overall long-term capital gain attributable to the depreciation actually or notionally claimed on the property.

Unrecaptured section 1250 gain remains capital gain, but it is capped at a maximum rate of 25% rather than the lower long-term capital gains rates that apply to the rest of the gain. The mechanical effect is that the sale produces two blended rates on a single transaction: the ordinary long-term capital gains rate, generally 15% or 20% depending on the taxpayer's income level, applied to the appreciation portion of the gain, and the higher 25% cap applied to the depreciation-attributable portion. A nonresident alien's gain is not subject to the net investment income tax under IRC §1411, which applies only to U.S. citizens and residents, but that exclusion does not offset the effect of the 25% unrecaptured section 1250 rate, which applies independently.

A worked example

A property purchased for $400,000, with $300,000 allocated to the depreciable building, is sold ten years later for $550,000 after selling costs of $30,000.

Item	Amount
Original basis	$400,000
Depreciation claimed or allowable over 10 years	$109,000
Adjusted basis at sale	$291,000
Amount realized (sale price less selling costs)	$520,000
Total gain	$229,000
Unrecaptured §1250 gain (taxed up to 25%)	$109,000
Remaining long-term capital gain (taxed at 15% or 20%)	$120,000

Compare this against an owner's intuition, which is usually built on the simple difference between purchase price and sale price: $550,000 minus $400,000, or $150,000. The actual taxable gain in this example is $229,000, roughly 53% higher than the intuitive figure, purely because of how depreciation moved the basis. And the $109,000 depreciation portion carries a materially higher rate cap than the rest of the gain. An owner who never claimed depreciation on this property still faces this same $229,000 figure, because the basis reduction applies whether the deduction was used or not.

How this interacts with FIRPTA withholding at closing

The Foreign Investment in Real Property Tax Act, at IRC §1445, requires the buyer to withhold 15% of the gross amount realized on the sale, not 15% of the gain, unless a reduced-rate exception applies or a withholding certificate is obtained in advance on Form 8288-B. On the example above, standard withholding at closing would be 15% of $550,000, or $82,500, calculated without any reference to basis, depreciation, or the actual gain at all.

An application for a reduced withholding certificate on Form 8288-B works by demonstrating that the seller's actual maximum tax liability is meaningfully lower than the standard withholding amount. Depreciation recapture and unrecaptured section 1250 gain work directly against that argument, because they increase the actual tax liability the application is trying to show is smaller than the standard withholding. An application built without accounting honestly for the recapture position overstates its own case, understates the real liability, and is a weaker application for it, not a more favorable one. The depreciation history has to be nailed down before the Form 8288-B application is drafted, not treated as an afterthought once the withholding number is already a problem.

Deferring the gain through a like-kind exchange

IRC §1031 allows a taxpayer to defer gain recognition by exchanging real property held for investment for other real property of a like kind, and this mechanism is available in principle to a foreign owner on the same terms as a U.S. person, since the section applies without regard to nationality or residence. Since the Tax Cuts and Jobs Act, §1031 applies only to real property; personal property exchanges no longer qualify.

The conditions are strict and unforgiving of delay. The replacement property generally must be identified within 45 days of transferring the relinquished property, the exchange must be completed within 180 days, and the exchange must be structured through a qualified intermediary who holds the sale proceeds so that the seller never has actual or constructive receipt of the funds. None of this makes the FIRPTA withholding obligation disappear on its own; the interaction between the exchange mechanics and the withholding obligation has to be planned before the closing, generally by obtaining a withholding certificate that reflects the deferred gain, rather than addressed after the fact. A §1031 exchange that is planned from the outset can work smoothly. One attempted after the sale has already closed, or with an identification deadline missed by even a day, generally cannot be salvaged.

What if prior years' rent was never reported?

The sale is frequently the moment unreported rental history surfaces, because computing the gain correctly on the year-of-sale return requires the property's full depreciation history, which in turn requires reconstructing what should have been reported in the years before.

Unreported rental income from earlier years is a separate compliance matter with its own routes back into good standing, and it is considerably easier to address deliberately, before a sale is under contract, than to reconstruct under the pressure of a closing date that a buyer and their lender are not going to move to accommodate. An owner who suspects prior years were never properly filed should treat that as a task to resolve before listing the property, not during escrow.

What records actually matter

The records that determine both the gain calculation and the strength of any withholding-reduction application are more extensive than most owners have kept:

• the original purchase closing statement, showing the price paid and the allocation between land and building
• invoices for capital improvements, kept separately from routine repair invoices
• depreciation schedules from every prior year's filing, or a reconstruction of what should have been claimed if none exist
• the full rental history, including any period of personal use that would affect the depreciation and gain computation
• the sale closing statement, showing the price received and the selling costs incurred

The line between an improvement and a repair matters more than owners expect. An improvement adds to basis and reduces the eventual gain; a repair was, or should have been, deducted in the year it was incurred and has no further basis effect. Records that mix the two together, or that were never kept with this distinction in mind, cannot reliably support either treatment when the return is prepared.

Ownership structure changes the mechanics

How the property is titled affects which return reports the sale and which withholding rules apply. A property held directly by an individual reports the sale on Form 1040-NR. A property held through a foreign corporation is subject to the same FIRPTA withholding mechanics at the entity level, and gain recognized by that foreign corporation can also trigger the branch profits tax under IRC §884 once the after-tax earnings are measured, a separate layer on top of the underlying capital gains treatment. A single-member LLC that is disregarded for U.S. tax purposes does not change the analysis; the individual owner is treated as the seller directly. Confirming exactly how title is held, and whether any entity in the chain has ever been a U.S. real property holding corporation under IRC §897(c), should happen early in planning a sale rather than at the title company's request during closing.

What to do before listing the property

Reconstruct the full depreciation position, whether claimed or merely allowable, before a sale is under contract, since it drives the gain calculation, the character of that gain between ordinary long-term rates and the 25% unrecaptured section 1250 rate, and any Form 8288-B application filed to reduce withholding at closing. If a §1031 exchange is a possibility, engage a qualified intermediary and confirm the identification and completion deadlines before the relinquished property closes, not after. And if any prior rental years were never reported, address that separately and in advance, since it is far easier to resolve outside a transaction timetable than inside one where a buyer's financing and a fixed closing date are already in motion.