Hold One Year and a Day: The Tax Rule That Pays You to Wait

The closing agent slid the settlement statement across the table and Trisha Mulvaney did the arithmetic in her head on the drive home. Sale price $310,000. She had paid $185,000 for the duplex twelve years earlier. Knock off about $21,700 in commission and closing costs and call the gain a little over $100,000. She had owned it twelve years, so it was long-term, so it was 15 percent, so it was roughly $15,500 to the IRS. She had looked up the rate table. She had checked it twice.

Her actual federal bill on that sale was just under $32,000.

Nothing went wrong at the closing. The extra sixteen thousand dollars came out of four words buried in the basis rules, and out of a deduction Trisha had spent twelve years deliberately not taking, because she believed skipping it kept her tax return simple and her future gain smaller.

Trisha is a composite character. She is assembled from a pattern that turns up over and over among people who own exactly one rental property and prepare their own returns, and her figures are invented for this article. The rule that caught her is not invented, and it catches people at every income level.

The rate table everybody memorises is missing its two highest rates

Ask any reasonably informed American what the long-term capital gains rates are and you will get the same answer: zero, fifteen, twenty. That answer is on every explainer, every brokerage help page, every year-end planning email. It is also incomplete in a way that matters enormously to anyone who has ever owned a rental, a share of a family farm, an inherited duplex, or a gold ETF.

The statute that sets the preferential rates does not contain three rates. It contains five. Alongside the familiar zero, fifteen and twenty, it carves out two categories of long-term gain and gives each its own ceiling: unrecaptured section 1250 gain, capped at 25 percent, and collectibles gain, capped at 28 percent. Both are long-term gains. Both are held more than a year. Both sit above the number that almost everyone believes is the maximum.

The 25 percent category is the one that reaches ordinary households, because ordinary households own rental property. A duplex in Des Moines, a condo kept after a remarriage, a parent’s house converted to a rental instead of sold. If it produced rent and it was depreciable, some slice of the eventual gain is riding in the 25 percent lane, and no bracket chart will warn you.

The four words that did the actual damage

Here is where Trisha’s story diverges from the ordinary version of this problem. Most people who get hit with a 25 percent slice at least got something for it: they claimed depreciation for years, sheltered rental income with it, and are now handing part of that benefit back at sale. Rough, but symmetrical.

Trisha never claimed a dollar of it. She had heard, somewhere, that depreciation was optional, and that skipping it would keep her Schedule E simple and leave her a bigger basis when she eventually sold. So for twelve years she reported the rent, deducted the mortgage interest, the property tax, the insurance and the repairs, and left the depreciation line empty.

The Internal Revenue Code does not permit that trade. When it tells you how to adjust the basis of property, it requires a reduction for depreciation allowed as a deduction — but specifies that the reduction shall be not less than the amount allowable. Allowed means what you actually claimed. Allowable means what the law would have let you claim. The rule takes the larger of the two.

Which means Trisha’s basis was reduced by twelve years of depreciation she never deducted. And the IRS’s own worksheet for computing the 25 percent slice instructs the taxpayer to use the smaller of the total gain or the depreciation allowed or allowable — the same phrase, doing the same work, one step further down the form.

Trisha’s twelve years, run all the way to the bottom line

What she should have been deducting

She bought the duplex for $185,000. The county’s assessment split it roughly $35,000 land, $150,000 improvements, and land is never depreciable — that split is the first thing a lot of self-preparers get wrong in the other direction. Residential rental property recovers over 27.5 years on a straight line, so the annual allowance was about $5,455. Over twelve years of ownership, the allowable depreciation came to roughly $65,455.

At her marginal ordinary rate of 22 percent, each of those unclaimed deductions was worth about $1,200 in tax. Twelve of them: about $14,400 that she simply declined to collect, spread across twelve Aprils, in a household where $1,200 was not a rounding error.

What the sale actually looked like

Sale price $310,000, less about $21,700 in commission and closing costs, gives an amount realised of $288,300. Her adjusted basis is $185,000 less the $65,455 of allowable depreciation, so $119,545. Total gain: $168,755 — already $65,000 larger than the $103,300 she had in her head, purely because of the basis reduction.

Then the gain gets split by category rather than taxed as one lump. The unrecaptured section 1250 slice is the lesser of the depreciation allowed or allowable and the total gain, so the full $65,455 lands there, at up to 25 percent: $16,364. The remaining $103,300 is ordinary long-term gain at her 15 percent rate: $15,495. Federal total: $31,859.

Her blended federal rate on that gain was just under 19 percent, on a sale she had planned around a 15 percent number. And Iowa’s own income tax sits on top of all of it; everything above is federal only.

The counterfactual nobody runs

This is the part worth sitting with. If Trisha had claimed depreciation properly for twelve years, her tax at sale would have been exactly the same $31,859. Not a dollar different. The basis reduction happens either way.

The entire cost of her decision, then, was the $14,400 of deductions she never took — plus twelve years of whatever that money would have earned had it stayed in her hands rather than the Treasury’s. She paid the recapture in full for a benefit she never received. It is one of the few genuinely one-sided outcomes in the tax code, and it happens quietly, to careful people, because the instruction sheet does not shout.

What nobody tells you about fixing it

The reflex, on discovering twelve years of missed depreciation, is to amend. That reflex is wrong twice over.

First, refund claims on amended returns run into a limitations period measured in a small number of years, so nine or ten of Trisha’s twelve years are simply closed to a refund. Second, and more fundamentally, missing depreciation for two or more consecutive years is not treated as a series of errors at all. The IRS treats it as having adopted an impermissible method of accounting, and a method is not corrected by amending — it is corrected by changing the method.

The instrument for that is Form 3115, Application for Change in Accounting Method, filed with a section 481(a) adjustment. The 481(a) adjustment computes the difference between the depreciation actually deducted and the depreciation that was allowable in all prior years, and — this is the useful part — a negative adjustment of that kind is generally taken into account in a single tax year. There is no three-year wall. A taxpayer can, in principle, sweep up a decade of missed depreciation into one current-year deduction.

Three things about that route that you will not find in the cheerful version:

It is a real filing, not a checkbox. Form 3115 with a depreciation change requires the property to be identified and the computation shown. This is the point at which most single-property landlords stop self-preparing, and honestly should.

The automatic-consent procedures carry restrictions in the final year of a trade or business — which, for someone whose entire rental operation is one duplex, is exactly the year they are selling it, and exactly the year they discover the problem. The cheapest version of this fix exists while you still own the building. It gets materially harder the month you list it.

Spreading the sale over time does not defer the expensive slice. If Trisha had carried paper and taken the price in installments, the regulations governing installment reporting take the unrecaptured section 1250 gain first, ahead of the ordinary long-term gain. The 25 percent bucket empties before the 15 percent bucket starts. Instalment sales spread the cheap part, not the dear part.

What the calculator settles

The honest reason people mis-plan a property sale is not ignorance of the rules; it is that the rules require you to hold four numbers at once and split a gain into categories before you can see the result. That is exactly the kind of thing to hand to a machine.

The number that matters is not the tax. It is the net. A seller who budgets 15 percent and owes 19 has overcommitted the proceeds by four points of a six-figure number, and that gap tends to be discovered after the down payment on the next thing has already been made.

What to actually do

Find out what your allowable depreciation is, whether or not you claimed it. This is not a research project: purchase price, land allocation, placed-in-service date, 27.5 years for residential. If you have never computed it, you are carrying a liability you have not been told about.

Fix the method while you still own the building. The catch-up route is widest when the property is still in service and the rental activity is ongoing. Deal with it in a quiet year, not in the year of a closing.

Allocate land honestly, and keep the evidence. Over-allocating to the building inflates depreciation now and recapture later; under-allocating forfeits deduction permanently. A county assessor’s split is defensible and free.

Track capital improvements as ruthlessly as you track rent. A new roof, a furnace, a full kitchen — these add to basis and reduce the eventual gain. Repairs do not. Twelve years of receipts in a shoebox are worth real money at the closing table, and nobody reconstructs them afterwards.

Model the sale in the year before you sell, not the April after. Almost every lever — timing across a low-income year, a like-kind exchange, holding until a step-up in basis at death, spreading a sale — requires a decision made before the deed changes hands. Afterwards you are a bookkeeper, not a planner.

What this does not mean

It does not mean depreciation is a trap to be avoided. The opposite: it is a genuine, valuable deduction, and the failure mode described here comes entirely from declining it. Claim it, every year, on schedule.

It does not mean the 25 percent ceiling applies to everybody who sells a rental. It is a maximum rate, not a flat one; a taxpayer whose overall income keeps them low enough in the brackets can face less. And where a property produced a loss on sale rather than a gain, the category question does not arise at all.

It does not mean the depreciation is confiscated forever. Property held until death generally receives a basis adjustment that erases the built-in gain, including the depreciated portion — which is precisely why some long-term landlords never sell. And a properly structured like-kind exchange defers the whole thing into the replacement property rather than triggering it.

And it does not mean the 0-15-20 framing is a lie. For someone selling ordinary stock or a broad index fund, it is exactly right, and this entire article is irrelevant to them. The point is narrower and more useful than a grievance: the published rate table describes one kind of asset well and two kinds of asset not at all, and the tax code never announces which one you are holding.

Trisha filed the return, paid the $31,859, and spent a genuinely bad evening working out that the twelve years of simplicity she had bought had cost her $14,400 and purchased nothing. She now owns a second rental. She has a preparer. She says the depreciation line is the only part of the return she checks twice.

Frequently asked questions

If I never claimed depreciation, do I really still owe tax on it?

Yes. The basis adjustment rules require a reduction for depreciation allowed as a deduction, but not less than the amount allowable — so the reduction happens whether or not you ever put a figure on the form. This is the single most expensive misunderstanding in small-scale landlording, and it is expensive precisely because the taxpayer thought they were being conservative.

Is unrecaptured section 1250 gain the same thing as depreciation recapture?

Related but not identical, and the distinction changes the rate. True recapture on personal property comes back as ordinary income at your full marginal rate. Unrecaptured section 1250 gain is the real-estate analogue: it stays a long-term capital gain, but it is pulled out of the 0-15-20 categories and given its own ceiling of 25 percent. Better than ordinary income, worse than the rate most sellers have budgeted for.

Can I just amend my old returns to claim the missed depreciation?

Usually not, for two separate reasons. The refund window on amended returns closes after a limited number of years, so the older ones are gone regardless. More importantly, once depreciation has been missed in two or more consecutive years the IRS treats it as an accounting method rather than an error, and methods are changed on Form 3115 with a section 481(a) adjustment, not by amending. The compensation is that the 481(a) route is not restricted to the last few years the way an amendment is.

Does the 25 percent rate apply when I sell my own home?

Only to the extent the home was ever depreciated — most commonly from a home-office deduction or from a period when it was rented out. A residence that was never depreciated has no unrecaptured section 1250 gain. A residence that spent four years as a rental before you moved back in usually does, and the principal-residence exclusion does not cover that portion of the gain.

Do gold ETFs really get taxed at the collectibles rate?

Funds that hold physical bullion are commonly treated as collectibles for this purpose, which puts long-term gains in the 28 percent category rather than the 15 or 20 percent one that holders assume applies because they bought it in a brokerage account like any other ticker. The wrapper looks like an equity fund; the tax treatment follows what is inside it. Check the fund’s own tax disclosure before you assume.

Regulatory source: the IRS publication on sales and other dispositions of assets sets out the depreciation-recapture rules, the Schedule D instructions contain the worksheet that computes the unrecaptured section 1250 slice from depreciation allowed or allowable, and Form 3115 is the method-change filing referred to above. The reconstruction of Trisha’s twelve years, the counterfactual showing that skipping depreciation changes nothing at sale, and the framing of the rate table as missing its two highest rates are this article’s own.

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Disclaimer: General information, not tax advice. Linqz is not a tax preparer or a registered adviser. “Trisha Mulvaney” is a composite character built for this article, not a real individual, and every dollar figure attributed to her is illustrative. Rate category boundaries, recovery periods and filing procedures change — confirm the current position on irs.gov, and take advice from a qualified preparer before acting on a property sale.