What Happens When You Sell a Fully Depreciated Property?

Selling a fully depreciated property usually produces a large tax bill because your adjusted basis has been reduced to zero by years of depreciation deductions, which means nearly the entire net sale price is taxable gain. That gain isn’t taxed at a single rate. The IRS splits it into pieces, each with its own treatment: depreciation recapture at up to 25% for real estate (or up to 37% ordinary rates for equipment), long-term capital gains at 0%, 15%, or 20% on any appreciation above your original cost, and a possible 3.8% net investment income surtax layered on top.

Why Almost the Entire Sale Price Is Taxable

Your taxable gain equals the amount realized minus your adjusted basis. Amount realized is the gross sale price less direct selling costs such as broker commissions, title fees, and legal expenses. Adjusted basis is what you originally paid, plus capital improvements, minus every dollar of depreciation you’ve claimed.

When a property is fully depreciated, that basis has been ground down to zero. So the arithmetic gets brutal in a hurry. Suppose you bought a commercial building for $800,000, put $80,000 into capital improvements, and claimed $880,000 in depreciation over 30 years. Your basis is $0. Sell for $1.2 million, pay $70,000 in closing costs, and your amount realized is $1,130,000. The gain is also $1,130,000. Every dollar of that is taxable; only the rate mix changes.

How the Gain Gets Split by Recapture Rules

Depreciation recapture rules exist so you can’t take deductions against ordinary income for decades and then convert all the gain into favorable capital gains at sale. The rules differ depending on what kind of property you sold.

Real Estate: Section 1250

Section 1250 covers buildings and other real property. Only “additional depreciation,” meaning the amount by which accelerated depreciation exceeded straight-line, gets recaptured as ordinary income.¹ Since the IRS has required straight-line depreciation on real property placed in service after 1986, there is usually no excess to recapture at ordinary rates.

Instead, the straight-line depreciation you claimed becomes “unrecaptured Section 1250 gain,” which carries its own maximum rate described in the next section.

Equipment and Personal Property: Section 1245

Section 1245 covers tangible personal property used in a business, including manufacturing equipment, vehicles, office furniture, and certain land improvements. The recapture is aggressive: the lesser of your total gain or your total depreciation is taxed as ordinary income at your marginal rate.² For a fully depreciated asset, that means the entire original cost recovered through depreciation gets taxed at ordinary rates, which top out at 37%.³ Only appreciation above the original cost qualifies for capital gains treatment.

The Four Rate Layers You May Pay

Unrecaptured Section 1250 Gain (Up to 25%)

For real estate, the straight-line depreciation you claimed is taxed at a maximum federal rate of 25%.⁴ This is where most real estate sellers get hit hardest, because the entire accumulated depreciation on a fully depreciated building falls into this bucket. The 25% figure is a ceiling: if your marginal ordinary rate is lower, you pay the lower rate instead.⁵

In the earlier example, that $880,000 of depreciation is unrecaptured Section 1250 gain. Taxed at 25%, that piece alone can produce $220,000 of federal tax before any other layer applies.

Ordinary Income (Up to 37%)

For Section 1245 personal property, the recaptured depreciation is taxed at your marginal ordinary rate, up to 37% for 2026.³ For most real estate sales using straight-line depreciation, this bucket is empty.

Long-Term Capital Gains (0%, 15%, or 20%)

Any gain that remains after the depreciation has been fully accounted for is Section 1231 gain, taxed at long-term capital gains rates. For 2026, the 0% rate applies to taxable income up to $49,450 (single) or $98,900 (married filing jointly); the 15% rate applies up to $545,500 (single) or $613,700 (married filing jointly); and the 20% rate applies above those thresholds.³ In the commercial building example, the $250,000 of gain above the $880,000 depreciation total lands in the 15% or 20% bracket for most sellers.

Net Investment Income Tax (Additional 3.8%)

A 3.8% surtax on net investment income applies when modified adjusted gross income exceeds $200,000 (single) or $250,000 (married filing jointly).⁶ Those thresholds are not indexed for inflation. The 3.8% stacks on top of your other rates, so long-term capital gains can effectively run at 23.8% and the unrecaptured 1250 gain can hit 28.8%. Sellers routinely forget this layer when they estimate the bill.

The Section 1231 Five-Year Lookback

The favorable capital gains treatment on the Section 1231 portion is not automatic. If you claimed net Section 1231 losses in any of the previous five years, your current Section 1231 gains get recharacterized as ordinary income up to the amount of those prior losses.⁷ The rule blocks taxpayers from deducting business-property losses at ordinary rates one year and then claiming capital gains treatment on gains a year later. A clean five years, and the lookback doesn’t touch you.

Deferring the Tax With a 1031 Exchange

A Section 1031 like-kind exchange defers the entire bill, capital gains and depreciation recapture alike, by rolling the proceeds into another qualifying investment property.⁸ The tax isn’t erased. It carries forward through a reduced basis in the replacement property.

Like-kind is interpreted broadly for real estate. You can trade a rental house for a warehouse, or vacant land for an apartment building, as long as both are held for business or investment use.⁹ Section 1031 applies only to real property. It does not cover equipment, vehicles, or other personal property.

Two deadlines control the transaction, and neither can be extended:

You must identify potential replacement properties in writing within 45 calendar days of closing on the sale.⁸
You must close on the replacement property within 180 calendar days of that sale, or by your tax return due date including extensions if that comes sooner.⁸

Miss either deadline and the whole exchange collapses, making the full gain taxable in the year of the original sale. To avoid constructive receipt of the proceeds, which also kills the deferral, most exchanges use a qualified intermediary to hold the funds between closings.¹⁰ Touching the cash, even briefly, can disqualify the transaction. To defer the entire gain, the replacement property must be equal to or greater in value, equity, and debt than what you sold. Any cash or non-like-kind property received (called boot) is immediately taxable up to the amount of realized gain.

Spreading the Tax With an Installment Sale

If a 1031 exchange isn’t practical, Section 453 lets you spread the gain across multiple years by taking the sale price in installments.¹¹ Each payment you receive is split between return of basis, gain, and interest income.

There’s a catch that hurts sellers of fully depreciated property: all depreciation recapture must be recognized in the year of sale, no matter when the cash arrives.¹¹ Only the gain above the recapture amount can be deferred across installment years. On a fully depreciated building, that means the biggest tax layer still hits in year one. The installment method mostly helps with the capital gains portion sitting above your total depreciation.

Eliminating the Tax Through a Step-Up in Basis

If the owner dies while still holding the property, heirs inherit it with a basis equal to fair market value at the date of death, not the decedent’s zero basis.¹² The step-up wipes out all accumulated depreciation and all pre-death appreciation. Heirs owe no recapture and no capital gains on that history.

If the heirs sell at or near the stepped-up value, taxable gain is minimal or zero. They can also start claiming fresh depreciation deductions on the stepped-up basis, restarting the depreciation clock. This is the mechanism behind the “buy, depreciate, exchange, and die” approach many long-term real estate investors follow: 1031 exchanges defer during life, and the basis step-up at death eliminates the accumulated deferred gain for heirs. The One Big Beautiful Bill Act, signed in 2025, permanently preserved this step-up rule going forward.

What Happens If You Keep Renting Instead

Selling isn’t the only path. Hold the property and the depreciation deductions are simply gone. Rental income is taxed without the offset that made real estate investing so tax-efficient in earlier years, and every dollar of net rental income lands on your return as ordinary income.

Operating expenses like property taxes, insurance, repairs, and management fees still come off. But depreciation, often the largest single write-off for rental owners, is finished. For investors in higher brackets, holding a fully depreciated property can look less attractive on an after-tax basis. The decision becomes a comparison: pay the recapture now and redeploy the capital (or roll into a 1031), or keep collecting rent taxed at a higher effective rate. The answer depends on your bracket, current rental yield, and whether a workable replacement property exists.

Reporting the Sale

You report the sale on Form 4797, which handles business property sales and depreciation recapture.¹³ Part III of that form is where the ordinary income recapture is calculated. Gain exceeding the recapture flows to Form 8949 and then to Schedule D, where the capital gains rates and the 25% unrecaptured Section 1250 rate get applied.¹⁴ The 3.8% net investment income tax, if it applies, is computed on Form 8960. The return for the year of sale is substantially more complex than a typical filing, and the cost of getting it wrong is high enough that professional preparation usually pays for itself.

1
Office of the Law Revision Counsel. 26 U.S. Code 1250 – Gain From Dispositions of Certain Depreciable Realty
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Office of the Law Revision Counsel. 26 U.S. Code 1245 – Gain From Dispositions of Certain Depreciable Property
3
Tax Foundation. 2026 Tax Brackets and Federal Income Tax Rates
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Office of the Law Revision Counsel. 26 U.S. Code 1(h) – Tax Imposed
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Internal Revenue Service. Topic No. 409 – Capital Gains and Losses
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Office of the Law Revision Counsel. 26 U.S. Code 1411 – Imposition of Tax
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Office of the Law Revision Counsel. 26 U.S. Code 1231 – Property Used in the Trade or Business
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Office of the Law Revision Counsel. 26 U.S. Code 1031 – Exchange of Real Property Held for Productive Use or Investment
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Internal Revenue Service. Like-Kind Exchanges – Real Estate Tax Tips
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Internal Revenue Service. Like-Kind Exchanges Under IRC Section 1031 – Fact Sheet
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Office of the Law Revision Counsel. 26 U.S. Code 453 – Installment Method
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Office of the Law Revision Counsel. 26 U.S. Code 1014 – Basis of Property Acquired From a Decedent
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Internal Revenue Service. Instructions for Form 4797
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Internal Revenue Service. Instructions for Form 4797