In Part 1 we revealed that Yes — depreciation recapture is still required even if you sell an investment property at break-even or at a loss, but only up to the amount of gain attributable to depreciation. The follow up may be what if you had a loan on the property that was paid off and how that may affect you.
December 20, 2025
By Al DiNicola, AIF®
1031 Tax Deferred Exchange Specialists & DST Advisor
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC, Member of FINRA/SIPC
In addition, can a §1031 exchange provide any relief. Click here to see Part 1. Depreciation Recapture Still an Issue When You Break Even ~ Part 1 – DST Education and Market News
A common misconception is: “If I sell at break-even or a loss, I shouldn’t owe depreciation recapture.” As we reviewed in Part 1 the recapture is based on depreciation taken (or allowed), NOT on gain vs. loss. Unfortunately.
There is a Depreciation recapture formula: Recapture = the lesser of (A) depreciation taken and (B) total gain. However, as with many investments there is a catch. When you pay off a loan, your “gain” for tax purposes may be different from what people call “break-even.” Tax law calculates gain using adjusted basis, not whether you walked away with cash. Yes, this can be confusing. We are not offering tax advice, and this article is intended to raise questions and awareness of potential options.
Why you may still have “Gain” when you think you’re breaking even. In most cases investors calculate break-even with a simple calculation (philosophy). The sale price minus loan payoff equal zero ($0). The investor thinks “I broke even.” But the IRS calculates taxable gain like this. The Sale Price minus the total closing costs and cost of sale minus the adjusted basis to arrive at the taxable gain.
Your adjusted basis goes down every year because of depreciation. Residential depreciation is over 27.5 years, and all other commercial properties depreciation schedule is over 39 years. There may be investors with fully depreciated properties in certain locations in the USA facing marginal appreciation even after being held for an extended period of time. So even if you receive no cash, the IRS may still show you sold for more than your adjusted basis. These types of calculation will create gain. Gain is recaptured as §1250 depreciation recapture. We are not offering tax advice, and the following is once again for illustration purposes.
Here is an example of a property being sold.
| Original purchase price: | $500,000 |
| Depreciation taken: | $200,000 |
| Adjusted basis ($500,000 − $200,000) | $300,000 |
| Loan payoff: | $400,000 |
| Selling price (net of closing cost) | $400,000 |
| Cash to you (did you think you broke even) | $0 |
IRS calculation:
| Sale price: | $400,000 |
| Adjusted basis: | $300,000 |
| Taxable gain | $100,000 |
| Depreciation taken: | $200,000 |
| Recapture (lesser of $200,000 and $100,000) | $100,000 |
| Recapture at 25% | $25,000 |
| Proceeds from sale above | $0 |
| Out of pocket taxes due (ouch) | $25,000 |
4. When You Sell at a True Loss (Below Adjusted Basis)
If you sell below your adjusted basis, there is no depreciation recapture, because recapture requires a gain.
| Original purchase price: | $500,000 |
| Deprecation taken | $200,000 |
| Adjusted basis: | $300,000 |
| Sale price net of costs: | $250,000 |
| Loan payoff: | $350,000 |
| You bring cash to close (OUCH) | $100,000 |
| Taxable gain ($250,000 – $300,000) | (–$50,000) |
Result: There is No depreciation recapture. There may be a deductible capital loss (if investment property). Even if you had a loan payoff of $350,000, taxable gain is based on adjusted basis, not cash flow.
Why Paying Off the Loan Confuses Things
The IRS doesn’t care how much loan you pay off. The loan payoff only affects cash, not taxable gain. In more expensive investment properties, you may pay off a $1M loan, receive $0 cash and still owe taxes. The reason is because taxes depend on adjusted basis vs. sale price, not cash.
This situation is common with older properties that have accumulated depreciation.
Investors who sell above the adjusted basis (even if they walk away with no cash) may or will have a taxable gain according to the IRS. If you sell below the adjusted basis (which may require bringing cash to closing) the IRS will not consider that a taxable gain. Regardless of the type of loan (recourse or no recourse) that does not affect the basis.
The big challenge and question may be what you do to avoid recapture. It would appear that you have only a few legal options. Investors would be wise to seek their own CPA advice. Here may be a few options.
A. Do a 1031 tax deferred exchange which completely defers depreciation recapture. We have authored many articles on the merits (and drawbacks) of a §1031 exchange. This becomes difficult with limited cash out from the sale. We will illustrate a potential option for some accredited investors.
B. Sell at a loss on the adjusted basis on which there would be no recapture but often require bringing cash to closing.
C. Convert to primary residence (complicated and limited) and some depreciation recapture still unavoidable.
Quick review on a §1031 exchange defers depreciation recapture because the IRS treats your sale and purchase as one continuous, uninterrupted investment—not as a taxable sale followed by a new purchase.
Here’s are the 1031 bullet points:
1. The IRS says you didn’t “sell” anything
2. Your old basis moves into the New Property (Carryover Basis)
3. The depreciation clock resets (with some limitations) … but the tax deferral stays
4. The deferred recapture follows you into the New Property
5. The “Swap Until You Drop” estate Strategy
Accredited investors may have an option, but suitability is always a concern. If the investor needs to write a check to the IRS for the recapture of depreciation are there any other options? One potential option may be to acquire an interest in a Delaware Statutory Trust (DST) that is highly leveraged. DSTs with high leverage are designed to maximize potential tax strategies. Highly leveraged DSTs may be referenced as “Zero” DST. Typically, the highly leveraged DST will not pay a distribution but will direct all payments to retiring the non-recourse debt on the property. We have seen this in several distribution centers (Amazon). Each investor situation is different and balancing the §1031 exchange is critically important. Three financial components need to be in place: replace the value, replace the debt and use all the cash. There is no easy solution when selling at break even. However, discovering potential strategies may be beneficial.
As always contact us for more information and a complimentary consultation.
NAMCOA® is a SEC registered investment advisory firm that provides comprehensive portfolio management, financial planning, and fiduciary decision-making services on behalf of retirement plan sponsors. Our Difference is summarized by our fiduciary approach which enables us to better meet portfolio and retirement plan objectives, resulting in stronger risk adjusted returns for investors and peace of mind for Clients. We also focus on alternative real estate investment. Many real estate investors are seeking tax deferred solutions utilizing §1031 exchanges or Opportunity Zones.
Alternative investments and DSTs are not for all investors. The acquisition of a certain alternative investments including DSTs is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your §1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC §1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email adinicola@namcoa.com.
This is not an offer to purchase or solicitation to purchase any security, as such be made only through an offering memorandum or prospectus. Investing in securities, real estate, or any investment, whether public or private, involves risk, including but not limited to the potential of losing some or all your investment dollars when you invest in securities. You should review any planned financial transactions that may have tax or legal implications with your personal tax or legal advisor. NAMCOA, LLC is a Registered Investment Advisor, regulated by SEC (Securities and Exchange Commission). Our company mailing address is 999 Vanderbilt Beach Road, Suite 200, Naples Florida 34108. Securities Offered through MSC-BD, LLC, Member of FINRA/SIPC. 5 Centerpointe Drive, Ste. 400 Lake Oswego, OR, 97035MSC-BD, LLC and NAMCOA are independently owned and are not affiliated.
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