The exit year: depreciation recapture on a rental property sale

A sale closes, one payment arrives, and the tax on the whole hold is settled in that year. The number the tax is computed on has very little to do with the size of that payment.

We develop and operate our own Ohio communities, so what follows is the sale sequence from the side that prepares the closing statement.

The four characters of gain, stated once

One sale produces four kinds of income, and they are taxed differently.

• Section 1245 recapture. The short-lived components a cost segregation study separated out: appliances, cabinetry, flooring, specialty lighting. Depreciation on them comes back as ordinary income, to the extent there is gain on those assets.
• Unrecaptured Section 1250 gain. The straight-line depreciation taken on the building itself. It carries a maximum federal rate of its own, above the long-term capital gain rate.
• Section 1231 gain. What is left after the first two, generally treated as long-term capital gain.
• The five-year lookback. Section 1231 gain is recharacterised as ordinary income to the extent of net Section 1231 losses claimed in the five preceding years.

Where those deductions came from is the subject of why new development produces large paper losses. What follows is the part that article does not: the order the exit-year numbers arrive in, and why the bill can outrun the cash.

The order the numbers are computed in

Nothing is computed on the deal as a whole. It is computed asset by asset, in a fixed sequence.

1. Amount realised. The contract price, less the costs of selling — brokerage, title, transfer taxes, legal — adjusted for the prorations settled at closing.
2. Allocation across asset classes. That amount is spread across land, land improvements, the building, and personal property; land is not depreciable and produces no recapture. The split follows the purchase agreement and the class detail from the cost segregation work.
3. Gain, class by class. Each class carries its own adjusted basis: what it cost, less the depreciation actually taken on it. Gain is the allocated price less that basis, computed for each class rather than once for the property.
4. Character. The four categories above are applied to those class-level gains.
5. Allocation to the partners. The partnership allocates the gain under the operating agreement, which need not track the cash: the cash follows the distribution waterfall, the gain follows the allocation provisions.
6. Your own return. Net investment income tax, state tax, released passive losses, and any other Section 1231 items you have that year.

Two investors in one deal can receive identical payments and report different income. The number that matters to you is set at step five, not at the closing table.

Why the tax can be larger than the cash you receive

Gain is price less basis. Cash is price less everything paid out of it. Those are different subtractions, and four things drive them apart.

The debt is repaid out of the price, and it is already inside the price. On a leveraged sale the loan payoff is the largest line on the closing statement, and it sits inside the amount the partnership is taxed on. Repaying it reduces what there is to distribute; it does not reduce the gain allocated to you. Your share of the partnership’s liabilities also drops to zero, and a decrease in that share is treated as a distribution of money to you — the debt leaves on both sides of the ledger, and only one of those sides is cash.

Depreciation lowered the basis every year of the hold. The deductions that made the early K-1s useful are what make the exit-year gain larger than the economic profit. Nothing was forgiven; it was deferred, and partly recharacterised.

Money that came back earlier is not in the final payment. A refinancing that sent capital back mid-hold reduced what is available at the exit and left the gain untouched.

Costs and the waterfall take cash, not gain. Selling costs, the entity’s final expenses, and whatever the operating agreement pays the sponsor at a capital event come out of the cash, on a different formula from the one allocating income.

The ending capital account is a balance, not a profit figure

Your capital account is a running ledger: contributions, plus income allocated to you, less losses allocated to you, less distributions. The sale posts one more entry — your share of the gain — and the final payment clears the balance and closes the account.

So the last wire is not a measure of how the deal did. It is the balance of an account after several years of entries, and a large part of it is money you put in yourself, a distinction worked through in when development capital comes back. Read that statement beside the closing statement; only one of them says what the payment is made of.

Ohio sources the gain to the building, not to the owner

Gain on the sale of Ohio real property is Ohio-source income because the building sits here, whatever state its owner lives in. That is true of the operating years too; what changes at the exit is size. The gain recognised is the whole hold’s rather than one year’s allocation, so what the partnership withholds or pays on your behalf is of a different order than during the hold.

Two things then belong to the exit rather than the ordinary years. A composite election made for the operating years does not necessarily carry a capital event, so the arrangement you have been filing under may not apply in the year that matters. And the route the partnership takes — withholding, a composite return, or an entity-level election — decides what you can claim at home, where a resident-state credit is generally capped at what your own state would have charged.

The mechanics of all three are set out in how to read the K-1 from a real estate partnership. It is easier to settle before the closing than after it.

The tax does not wait for the last dollar

Not all of the price arrives on the closing date. A buyer may hold back against a repair obligation, an indemnity, or an unsettled proration, and the partnership holds its own reserve before the final distribution: unpaid invoices, the last tax return, the cost of winding the entity up. An exit is often more than one payment, and the last can trail the closing by months — part of treating the position as illiquid for its whole life, including its end.

The gain does not wait. It is computed on the full amount realised at closing, the held-back portion included, so the tax attaches to money that has not landed. Where a sale is genuinely an installment sale — which a holdback on its own does not make it — the ordinary recapture on the short-lived components is generally recognised in the year of sale rather than as payments come in. How the rest is reported is a question for your CPA.

The timing runs the other way too: estimated tax can fall due in the quarter of the closing, months before the partnership’s return exists, so a sponsor’s estimate is what you and your CPA work from.

What the suspended losses do in the same year

For an investor who could not use the early losses, this is the year they come back. Section 469(g) releases the whole suspended balance on a fully taxable disposition of the entire interest to an unrelated party, and the release lands on the same return as the gain.

Whether you have a balance to release was decided years earlier, by your own income rather than by the deal, and what a released balance is worth depends on the character split above. Whether a rental loss can reach your other income covers both.

A like-kind exchange defers the computation rather than settling it, and it is made by the entity that owns the property rather than by an individual partner.

Questions to settle before the exit year, not during it

• What does the operating agreement say about the distribution order at a capital event, and about the final true-up?
• Will the partnership withhold for nonresident owners, file a composite return, or make an entity-level election — and does your resident state credit it?
• What split across asset classes does the sponsor expect at sale, and what does that do to the ordinary share?
• What holdback is likely, and how long does the second payment usually take?
• When will the K-1 arrive, and will there be an estimate in time for the quarterly payment?

The first is answered by the partnership agreement itself; the rest by the sponsor. Our after-tax return calculator runs a sale case against a refinance-and-hold case with the assumptions written out.

The price all of this is computed from

Every number above starts with the price a buyer pays on the day, and a buyer underwrites the income the building actually produces. That is why our pro formas use untrended rents: a project is tested against what its submarket rents for now rather than a rent growth curve that has to arrive. A building underwritten to a rent its submarket already supports can be checked against leases signed down the street. One underwritten to a rent that has to arrive later cannot be checked at all. Rents at our communities are set at or below market, and a deal that does not make sense at today’s rents is not good enough to build.

That is how the underwriting is done, not a claim about what a sale will produce. Private real estate development is illiquid and speculative: a hold can run longer than targeted, a sale may not clear the debt above it, and investors may lose some or all of the capital they commit. No return is guaranteed. Tax law changes, and the character split above depends on facts specific to your own return. What is set out here is how the computation runs, not a guarantee of any particular result. Take it to your own CPA before the closing rather than after it.