Depreciation Recapture at Sale: What Your Final K-1 Shows
The tax deferred during the hold arrives in the year of sale, split into pieces with different rules. The final Schedule K-1 reports each piece, most of them in a box of their own.
During the hold, depreciation is the reason a syndication can pay you cash and report a loss. At the sale, the bill for that arrives. The final Schedule K-1 reports the gain in several pieces, each with its own rule, and the depreciation you were allocated decides how large the expensive pieces are.
This article follows those pieces in order. It explains the mechanics and does not work out anyone's tax, which depends on facts only you and your adviser have.
Why depreciation turns into gain¶
Depreciation reduces the partnership's tax basis in the property each year. When the property sells, gain is the sale price less that reduced basis. Every dollar deducted during the hold therefore adds a dollar of gain at the sale, other things being equal.
The code does not tax all of that gain at the same rate. It traces which part came from depreciation and which kind of property the depreciation was taken on. That tracing is what depreciation recapture means.
Three kinds of gain¶
Section 1245 gain: personal property. Carpet, appliances, cabinetry and the other components a cost segregation study reclassifies are Section 1245 property. Gain on them is treated as ordinary income up to the depreciation taken, including any bonus depreciation. This is the piece that cost segregation enlarges.
Unrecaptured Section 1250 gain: the building. Section 1250 covers depreciable real property. Section 1250 itself treats as ordinary income only "additional depreciation," meaning depreciation above straight-line, and buildings are depreciated on a straight-line basis. What is left is unrecaptured Section 1250 gain: the part of long-term gain on real property that comes from depreciation. Section 1(h) taxes it at a maximum rate of 25% for individuals.
Section 1231 gain: the rest. Gain on business real property held for more than a year that is not recaptured is Section 1231 gain. If your net Section 1231 result for the year is a gain, it is generally treated as long-term capital gain. There is one exception worth knowing. Section 1231(c) treats it as ordinary income to the extent of net Section 1231 losses you deducted in the five preceding years.
Where each piece appears on the K-1¶
| Piece of the gain | Where it is reported | How it is taxed |
|---|---|---|
| Section 1245 recapture | Inside the partnership's ordinary or rental real estate income, not in a box of its own | Ordinary income |
| Unrecaptured Section 1250 gain | Box 9c | Maximum 25% rate for individuals |
| Net Section 1231 gain | Box 10 | Generally long-term capital gain, subject to the five-year lookback |
A worked example¶
The figure that matters most in that example is not the total gain. It is the split. Two deals with identical total returns can produce very different tax at the exit, depending on how aggressively they depreciated during the hold.
Selling your interest instead of waiting for the sale¶
If you sell your partnership interest before the property is sold, which is rare given how illiquid LP interests are, the result is similar in outline. Section 751 treats the part of your gain that corresponds to the partnership's Section 1245 recapture as ordinary income. The Treasury regulations under Section 1(h) apply the same look-through to unrecaptured Section 1250 gain. The recapture follows the interest, not just the property.
Two things that arrive with the final K-1¶
Suspended passive losses. Losses you could not use during the hold under the passive activity rules are generally released when you dispose of your entire interest in the activity in a fully taxable transaction, under Section 469(g). For many W-2 investors, that is the year the depreciation deductions finally do something.
Basis. Your gain is measured against your outside basis, which has moved every year of the hold. Capital accounts and basis explains why that figure rarely equals what you invested, and why distributions and debt changes move it.
What to ask before investing¶
None of those answers makes a deal better or worse. They tell you what the tax benefit shown during the marketing actually defers, and where it is expected to come due. Deferral planning, where it exists, is outlined in 1031 exchanges and LP interests, and it has to be arranged before the sale, not after.
Primary sources
Every factual claim above is traceable to a filing, a rule or an agency publication. These are the ones this article relies on.
- IRS Publication 544, Sales and Other Dispositions of Assetsirs.gov
- IRS, Partner's Instructions for Schedule K-1 (Form 1065)irs.gov
- 26 U.S.C. 1250, gain from dispositions of certain depreciable realtylaw.cornell.edu
- 26 U.S.C. 1245, gain from dispositions of certain depreciable propertylaw.cornell.edu
- 26 U.S.C. 1, including subsection (h) on capital gain rateslaw.cornell.edu
Questions readers ask
What is depreciation recapture in a real estate syndication?
The part of the gain on sale that comes from depreciation deducted during the hold. Depreciation lowered the property's tax basis, so it raises the gain when the property is sold, and the code taxes that part of the gain under its own rules.
What is unrecaptured Section 1250 gain?
The part of the long-term gain on depreciated real property that comes from straight-line depreciation. For individuals it is taxed at a maximum rate of 25% under Section 1(h). It appears in box 9c of a partnership Schedule K-1.
Does cost segregation change the recapture?
Yes. Components reclassified as personal property are Section 1245 property, and gain on them is recaptured as ordinary income to the extent of the depreciation taken. That is usually a higher rate than applies to the building.
What happens to my suspended passive losses when the deal sells?
When you dispose of your entire interest in a passive activity in a fully taxable transaction, Section 469(g) generally releases the suspended losses from that activity. How that interacts with your own return is a question for your tax adviser.
Is there a way to defer the tax at sale?
Planning options exist, but a limited partner cannot usually exchange a partnership interest for another property on their own, and any planning has to happen before the sale. See the article on 1031 exchanges and LP interests.
Read next
- TaxDepreciation, Cost Segregation and Bonus DepreciationA deduction requiring no cash outlay, accelerated into the early years. It changes the timing of deductions, not the total, and it enlarges recapture at sale.
- TaxThe Schedule K-1 a Syndication Sends You, Box by BoxThe form reports your allocated share of the partnership's income, deductions and capital. It will not match the cash you received, and it is not supposed to.
- TaxCapital Accounts, Basis, and What Happens at ExitTwo running balances that look alike and decide different things: how much loss you can deduct, and how the final distribution is actually split.
This article sits in section V, Tax and Reporting, which runs to 9 articles in reading order.