STR Depreciation Recapture on Sale (2026 Guide)

The cost segregation study that produced a $240,000 first-year deduction did not eliminate tax. It moved it. When you sell, the depreciation comes back, and a meaningful portion of it comes back at ordinary rates rather than capital gain rates.

Understanding how the layers work is what separates an investor who plans the exit from one who is surprised by it.

The Three Layers of Gain

On sale, total gain is the amount realized less adjusted basis, where adjusted basis is original cost plus improvements less all depreciation claimed. Because the study accelerated depreciation, adjusted basis is lower and gain is larger than it otherwise would have been.

That gain is then allocated into three layers, each taxed differently, in a specific order.

Layer one is Sec. 1245 recapture. Under IRC Sec. 1245, gain on personal property is recaptured as ordinary income to the extent of depreciation claimed on it. All of the five-year property identified in the study, the appliances, furniture, carpet, decorative lighting, and specialty finishes, is Sec. 1245 property. This layer is taxed at ordinary rates up to 37%.

Layer two is unrecaptured Sec. 1250 gain. This is the straight-line depreciation claimed on the building structure and on 15-year land improvements. Because MACRS depreciates real property on a straight-line basis, there is generally no Sec. 1250 ordinary recapture, but this gain is taxed at a maximum 25% rate under IRC Sec. 1(h)(1)(E) rather than the lower long-term capital gain rate.

Layer three is the remaining gain, which is long-term capital gain taxed at 0%, 15%, or 20% depending on income, plus the 3.8% net investment income tax where applicable.

Why the Study Increases the Ordinary Layer

Without a study, essentially all depreciation on a rental is straight-line on the building, producing unrecaptured Sec. 1250 gain at 25%.

With a study, 20% to 30% of basis moved into Sec. 1245 property, and the depreciation on that property recaptures at ordinary rates.

On a property where the study identified $190,000 of five-year property fully deducted in year one, that $190,000 recaptures as ordinary income on sale.

At a 37% ordinary rate versus a 25% unrecaptured Sec. 1250 rate, the differential cost is 12 points on $190,000, or approximately $22,800.

That is the true cost of the study's acceleration, and it should be compared against the benefit rather than ignored.

The Arithmetic Usually Still Favors the Study

The comparison is not deduction versus recapture. It is the present value of a deduction taken now against the present value of tax paid at sale.

A $190,000 deduction at a 37% rate saves $70,300 today. The recapture on the same $190,000 at a 37% rate costs $70,300 at sale. If the sale is seven years out, the taxpayer had free use of $70,300 for seven years.

At an 8% opportunity cost, that use is worth roughly $50,000. The study wins clearly.

The arithmetic reverses in two cases. A very short hold, where the deferral period is too brief to generate meaningful value. And a taxpayer whose rate is materially higher at sale than at deduction, which can happen for someone early in a career or someone whose income spikes in the sale year.

For most STR investors in a high bracket planning a multi-year hold, the study is clearly correct.

Method One: 1031 Exchange

A like-kind exchange under IRC Sec. 1031 defers the entire gain, including both recapture layers. No tax is recognized, and the deferred gain carries into the replacement property through a reduced basis.

Since 2017, Sec. 1031 applies only to real property. The furniture, appliances, and other personal property in a furnished short-term rental is not like-kind and is boot, triggering recognition of the Sec. 1245 recapture attributable to it.

That is a real limitation for furnished properties. An investor exchanging a short-term rental with $58,000 of furnishings will recognize the recapture on that personal property even in an otherwise fully deferred exchange.

The practical answer is to structure the sale so that personal property is sold separately with non-exchange funds allocated to it, and to accept the recapture on that portion while deferring the real property gain.

Method Two: Installment Sale

An installment sale under IRC Sec. 453 spreads capital gain across the years payments are received, keeping the seller in lower brackets and reducing net investment income tax exposure.

But IRC Sec. 453(i) requires that Sec. 1245 recapture be recognized in full in the year of sale, regardless of how little cash is received.

For an STR with heavy Sec. 1245 property from a study, this means the ordinary income layer is due immediately. A seller taking a small down payment can owe more tax than they received.

The planning answer is to size the down payment against the recapture liability. A seller with $190,000 of Sec. 1245 recapture needs enough cash at closing to fund roughly $70,000 of tax before anything else.

Method Three: Hold Until Death

Under IRC Sec. 1014, property held until death receives a stepped-up basis equal to fair market value at the date of death. All accumulated depreciation and all appreciation disappear for income tax purposes. There is no recapture.

This is the cleanest outcome available and it is the actual endgame of a buy, depreciate, refinance, hold strategy.

An investor who runs studies, refinances to extract equity tax free, exchanges rather than sells, and holds until death never pays the deferred tax. The heirs take a stepped-up basis and can sell with little or no gain.

The estate tax analysis is separate and depends on the size of the estate relative to the exclusion, but for most investors the income tax result is complete elimination.

Worked Example: STR Sale Six Years Out

An investor bought a short-term rental for $920,000 with $175,000 of land, ran a study reclassifying 28%, and furnished it for $52,000. Total first-year depreciation was approximately $260,600.

Six years later they sell for $1,340,000. Total depreciation claimed across six years is $342,000, of which $208,600 was on Sec. 1245 property including furnishings and $133,400 was straight-line on structure and land improvements.

Adjusted basis is $972,000 less $342,000, or $630,000. Total gain is $710,000.

Layer one: $208,600 of Sec. 1245 recapture at ordinary rates. At 37%, that is $77,182.

Layer two: $133,400 of unrecaptured Sec. 1250 gain at 25%, or $33,350.

Layer three: $368,000 of long-term capital gain at 20% plus 3.8% net investment income tax, or $87,584.

Total federal tax is approximately $198,116.

Had the investor executed a 1031 exchange instead, allocating $38,000 of the price to remaining personal property sold outside the exchange, they would have recognized only the recapture attributable to that personal property and deferred approximately $180,000 of tax.

Frequently Asked Questions

Does cost segregation increase my tax when I sell?

It shifts part of the gain from the 25% unrecaptured Sec. 1250 rate to ordinary rates up to 37%, because the reclassified five-year property is Sec. 1245 property. On $190,000 of such property that differential is roughly $22,800, which is generally far less than the value of the deferral.

How is STR gain taxed on sale?

In three layers: Sec. 1245 recapture on personal property at ordinary rates, unrecaptured Sec. 1250 gain on the building and land improvements at up to 25%, and remaining gain as long-term capital gain, plus the 3.8% net investment income tax where applicable.

Does a 1031 exchange defer the recapture?

For the real property, yes, entirely. But since 2017 Sec. 1031 applies only to real property, so furniture and appliances in a furnished STR are boot and the recapture attributable to them is recognized. Allocate and sell the personal property separately.

Can I spread the recapture over an installment sale?

No. Under IRC Sec. 453(i), Sec. 1245 recapture is recognized in full in the year of sale regardless of cash received. Size your down payment against the recapture liability, since a small down payment can leave you owing more tax than you collected.

Is there any way to avoid recapture entirely?

Holding until death. Under IRC Sec. 1014 the basis steps up to fair market value at death, eliminating all accumulated depreciation and appreciation for income tax purposes. This is the actual endgame of a buy, depreciate, exchange, hold strategy.

Depreciation Recapture When You Sell a Short-Term Rental