IRS Can Tax Rental Depreciation at Sale Even if a Landlord Never Claimed It

A September 18 report from 24/7 Wall St. underscored a tax rule that can surprise small landlords near a sale: the IRS may treat depreciation as taken even when the owner never claimed it. For older rental owners who filed Schedule E for years but skipped depreciation, that can mean a lower tax basis at sale and a recapture bill tied to deductions they never actually used.

The scenario described is straightforward. A landlord deducted repairs, mortgage interest, and property taxes, but not depreciation, believing that skipping the deduction would keep taxes lower when the property was eventually sold. Under the rule highlighted in the report, that is not how the sale is taxed.

What Changed

No new law was announced on September 18. The development was renewed attention to a longstanding rule for rental real estate: under Section 1250, depreciation that was allowed or allowable can affect gain on sale. In practice, that means the owner's basis may be reduced by depreciation the owner was entitled to claim, whether or not the deduction ever appeared on a return.

For residential rental property, the report said the asset is depreciated over 27.5 years under the modified accelerated cost recovery system. On a property with a $200,000 depreciable basis, that works out to roughly $7,200 a year. Skip that deduction for 20 years and the missed depreciation is around $140,000, according to the example in the report.

The tax cost shows up later. The taxable gain calculation can reflect that missed depreciation anyway, and the recaptured portion may be taxed as unrecaptured Section 1250 gain at rates of up to 25%, the report said.

Who Is Affected

This issue matters most for long-time individual landlords, especially those who self-prepared returns or relied on a preparer who did not build a depreciation schedule. It may also affect owners who inherited a rental and kept filing without fully reconstructing the property's tax basis and prior-year deductions.

The potential damage is larger when two facts overlap:

• The property has been held for many years. More years means more missed depreciation that is still treated as allowable.
• The property has appreciated sharply. The report noted that the Case-Shiller National Home Price Index was near 337 this summer, the highest reading in the history cited there, increasing the odds that older rentals now carry sizable embedded gains.

That combination can produce two layers of tax at sale: capital gain from appreciation and depreciation recapture tied to prior allowable deductions.

The After-Tax Math

Example: assume a landlord had a $200,000 depreciable basis in a residential rental and failed to claim depreciation for 20 years.

Using those round numbers, a landlord could face tax on roughly $140,000 of depreciation-related gain even though that owner never received the annual deductions. At a 25% rate, the recapture piece alone could imply up to about $35,000 of federal tax in this simplified example. That does not include any separate capital-gain tax on appreciation.

The important point is not the exact dollar figure in every case. It is that skipping depreciation does not necessarily preserve basis for sale. Instead, households may lose the annual deduction and still face the sale-time tax effect.

Moves to Discuss With Your Advisor

The main planning item raised in the report is Form 3115, Application for Change in Accounting Method. According to 24/7 Wall St., filing Form 3115 before a sale may let the taxpayer claim a Section 481(a) adjustment, which is a catch-up deduction for depreciation that should have been taken in prior years.

That does not erase depreciation recapture on a later sale. But it may allow the owner to finally use the missed deduction against current-year ordinary income. The report said that could include rental income, pension distributions, IRA withdrawals, or other ordinary income, depending on the taxpayer's situation.

It also outlined a second path: a 1031 exchange into another rental property, which the report said can defer both capital gain and depreciation recapture. For older owners, that path may be more relevant when estate planning is the main objective and the replacement property is expected to be held until death.

These are not do-it-yourself decisions. Timing matters, especially if the property is already listed or under contract. Households in this situation may want to review prior Schedule E filings, confirm whether depreciation was ever claimed, and discuss the sequencing with a CPA before closing a sale.

What to Watch

The practical issue now is timing. The report warned that the catch-up deduction route depends on filing mechanics and a timely return. For landlords who discover the problem only after a closing, some options may be harder or unavailable.

Owners preparing to sell a long-held rental may want to watch for three things in the coming months:

1. Whether a depreciation schedule exists. If not, the tax file may need reconstruction before a sale moves forward.
2. How much ordinary income is available in the year of a catch-up deduction. The value of the deduction depends in part on what it can offset.
3. Whether a sale, a delay, or a like-kind exchange best fits the household's broader plan. That is a tax and estate planning question, not just a real-estate one.

For affluent families with rental property acquired decades ago, this is a reminder that overlooked line items on Schedule E can become expensive at exit. The rule highlighted on September 18 is old, but its impact can feel new when a sale is finally on the table.

After TAX is an independent publication. Articles are general information, not tax, legal or investment advice. Consult a licensed professional about your situation.