Once a former home is genuinely converted to a rental, the owner starts claiming depreciation on it every year, and that depreciation lowers taxable rental income while it is owned. It also creates a bill that comes due on sale, separate from and in addition to ordinary capital gain, and separate from what the Section 121 exclusion can shelter.
That bill is called depreciation recapture, and for residential real estate it is taxed as unrecaptured Section 1250 gain at a rate capped at 25 percent, regardless of the owner's ordinary income bracket. The Section 121 exclusion does not reach this portion of the gain even if the owner otherwise qualifies for the full $250,000 or $500,000 exclusion on the rest.
A like-kind exchange, available once the property has become genuine investment real estate, defers recapture the same way it defers the underlying capital gain, provided the exchange is structured and completed correctly under the like-kind rules.
From the date a former residence starts being rented, the building portion of its value, not the land, is depreciated over 27.5 years under the straight-line method required for residential rental property. A homeowner who converts a home with a $300,000 building value and rents it for eight years before selling will have claimed roughly $87,000 in depreciation by that point.
Every dollar of that depreciation reduced taxable rental income during the years it was claimed. On sale, that same amount is recharacterized: it comes out of the gain calculation as unrecaptured Section 1250 gain, taxed at up to 25 percent, ahead of whatever rate applies to the remaining gain.
The Section 121 exclusion was written to protect a homeowner's gain from tax, not to erase the tax benefit already received from depreciation deductions taken during a rental period. The statute specifically carves out gain attributable to depreciation claimed after May 6, 1997, from the exclusion, even for a property that later returns to primary-residence status or is sold while still a rental.
This means a seller who qualifies for the full $500,000 joint exclusion on the appreciation portion of the gain can still owe tax on the recapture portion, calculated separately and added on top.
A completed like-kind exchange defers both the capital gain and the depreciation recapture on the relinquished property, rolling the deferred amounts into the replacement property's basis rather than triggering tax at the time of sale. This only applies to property held for investment use at the time of the exchange; it does not reach back and retroactively cover a period when the property was a personal residence.
The deferred recapture does not vanish. It carries forward into the replacement property and becomes payable, along with any additional recapture accumulated on the replacement, whenever the owner eventually sells without exchanging again, unless the property passes to heirs first, at which point stepped-up basis rules apply.
An owner who wants the option to defer recapture through a 1031 exchange needs the property to look like investment real estate by the time of sale: a lease in place, rent collected at market rates, and depreciation claimed on returns for a period long enough to support that characterization, generally interpreted as at least one or two years of genuine rental use and intent.
Converting a home to a rental for a few months immediately before a planned sale, specifically to try to access exchange treatment, is the pattern the IRS scrutinizes most closely. Rental history, lease terms, and reported income need to reflect an actual change in how the property was used and held, not a formality layered on top of a sale that was already planned.
Deferring recapture through an exchange only makes sense if the owner also wants to remain invested in real estate. An owner who wants to exit real estate ownership entirely and take proceeds in cash will pay the recapture tax regardless, since deferral requires reinvesting through a qualified intermediary into a new like-kind property.
For an owner who wants to stay invested but is tired of finding tenants and fielding repair calls, a DST allocation can serve as the replacement property, deferring the recapture while converting the ownership into a passive interest rather than another direct rental to manage.
