FIRPTA and Cost Segregation Recapture on a Vacation Rental Sale

A vacation rental that has been through a cost segregation study with bonus depreciation creates a different recapture profile than a standard long-term rental depreciated on the straight-line method. The general depreciation recapture mechanics (zero ordinary recapture under section 1250(a) on a straight-line building held more than a year, up to 25% on the unrecaptured section 1250 gain) still apply to the building component. But the personal property that a cost seg study reclassifies (appliances, carpet, cabinetry, lighting, certain electrical and plumbing) is IRC 1245 property, and section 1245 recapture is ordinary income at your marginal rate, not capital gain at a 25% ceiling. When bonus depreciation has been claimed at 100%, the entire cost of those reclassified components comes back as ordinary income on sale.

Why does cost segregation make the recapture worse?

A cost segregation study reclassifies components of the property from 27.5-year residential rental property (section 1250 property, depreciated on the mandatory straight-line method under IRC 168(b)(3)(B)) to shorter-lived property classes: 5-year, 7-year, and 15-year property. The components reclassified as personal property (appliances, carpet, window treatments, decorative lighting, certain electrical and plumbing, furniture if included in the sale) are IRC 1245 property, and section 1245 recapture is different from section 1250 recapture. Section 1245(a)(1) treats as ordinary income the lower of the total depreciation taken (or allowable) on the property, or the gain on the property. There is no straight-line carve-out, no “additional depreciation” calculation, and no 25% ceiling. The full depreciation comes back at ordinary rates.

With 100% bonus depreciation (now permanent under the Big Beautiful Bill Act, IRC 168(k)), every dollar reclassified to a shorter-lived class was expensed in the year of purchase. On a $500,000 condo where a cost seg study reclassified $100,000 to 5-year and 7-year property, the entire $100,000 was deducted in year one. When you sell the property, that $100,000 comes back as ordinary income under section 1245, regardless of the sale price. If the property appreciated, the gain on the 1245 components is the entire $100,000 of depreciation (because the adjusted basis of those components is zero after bonus depreciation), and it is taxed at your marginal ordinary rate, not at the 25% ceiling for unrecaptured 1250 gain.

How do the three layers stack on a sale?

The gain from selling a cost-seg’d vacation rental separates into three components, each taxed differently.

Layer 1: Section 1245 recapture (ordinary income). The personal property components reclassified by the cost seg study. The recapture amount is the lower of the depreciation taken (the full cost if 100% bonus depreciation was claimed) or the gain on those specific assets. If the total sale price is allocated partly to these components (as it typically is in a cost segregation-aware closing), the gain on each component is measured against its own adjusted basis (zero, if fully expensed). This layer is taxed at ordinary graduated rates on your 1040-NR.

Layer 2: Unrecaptured section 1250 gain (25% ceiling). The building component, depreciated on the mandatory straight-line method. On a building held more than a year, ordinary section 1250(a) recapture is zero because there is no excess depreciation above straight line. But the depreciation comes back as unrecaptured section 1250 gain under IRC 1(h)(1)(E), capped at 25%. This layer equals the total straight-line depreciation taken on the building component over the holding period.

Layer 3: Long-term capital gain (regular rates). Whatever gain remains after layers 1 and 2 is capital gain taxed at the regular long-term capital gains rates (0%, 15%, or 20% depending on the bracket, plus the 3.8% net investment income tax if applicable).

When does FIRPTA withholding fall short of the tax?

The standard FIRPTA withholding under IRC 1445(a) is 15% of the amount realized (the sale price, not the gain). On a property with heavy cost segregation and a short hold, the actual tax can exceed 15% of the sale price because the section 1245 recapture is taxed at ordinary rates that can reach 37%. This is most likely when the property has not appreciated much but has significant cost-seg depreciation to recapture.

The reverse is also common: on a property that has appreciated significantly, the 15% withholding can exceed the actual tax because the withholding is based on the amount realized, not the gain. A property purchased for $500,000 and sold for $520,000 with $120,000 of depreciation has a gain of $140,000 but a withholding of $78,000 (15% of $520,000), far exceeding any plausible tax on $140,000 of gain.

In either direction, the seller files a 1040-NR after the close of the tax year to reconcile the withholding against the actual liability. If the withholding exceeds the tax, the excess is refunded (processing time is typically 6-12 months for NRA refunds). If the withholding is less than the tax, the balance is due with the return.

How does the 8288-B withholding certificate work?

Form 8288-B is an application to the IRS to reduce the FIRPTA withholding to an amount that more closely approximates the actual tax. The application requires a calculation of the estimated gain and tax, broken down by component (1245 recapture, unrecaptured 1250 gain, capital gain). The IRS reviews the application and issues a withholding certificate specifying the reduced amount.

The practical constraints: the application must be filed before closing (the IRS will not reduce withholding retroactively). Processing time is approximately 90 days from the date of receipt. The application fee is $1,510 (2025 user fee schedule under Rev. Proc. 2025-1), payable with the application. An ITIN is required on the application; if the seller does not yet have an ITIN, the ITIN application must be filed simultaneously or in advance.

The 8288-B is worth filing when the expected difference between the standard withholding and the actual tax is large enough to justify tying up less capital for 6-12 months. On a $750,000 sale where the actual tax is $80,000 and the standard withholding is $112,500, the 8288-B saves $32,500 of cash tied up until the refund arrives. On a $300,000 sale where the difference is $5,000, it is not worth the fee and the lead time.

What happens on the Canadian side of the sale?

Canada taxes the same gain, with its own calculation. The adjusted cost base (ACB) is computed in Canadian dollars using the exchange rate at the date of purchase. The proceeds are converted at the exchange rate on the date of sale. Capital gains are included in income at 50% (the inclusion rate for gains above the $250,000 annual threshold increased to 66.67% effective June 25, 2024, per the 2024 Federal Budget, but this applies to the portion of capital gains above $250,000 in a given year). The US tax paid (the actual tax, not the withholding) is creditable against Canadian tax on the same income through Form T2209.

The cost segregation complicates the Canadian calculation because Canada does not have the same concept. CCA (capital cost allowance) classes do not align with the US recovery periods, and the bonus depreciation that sheltered income on the US return has no Canadian equivalent. If you claimed CCA on the property on the Canadian side (as part of the T776 rental reporting), the CCA recapture on the Canadian return follows subsection 13(1) of the Income Tax Act and applies to the extent the proceeds exceed the undepreciated capital cost (UCC) of the class. The Canadian recapture is ordinary income, similar in character to the US section 1245 recapture but calculated on different amounts because the CCA classes and rates differ from the US depreciation.

The foreign tax credit calculation requires matching the US and Canadian characterization of each component of the gain. The US section 1245 ordinary recapture is a different character from the Canadian capital gain on the same asset, which can create a credit mismatch where the US ordinary tax exceeds the Canadian capital gains tax on the same component, leaving stranded US credits.

What should I do next?

If you own a vacation rental with cost segregation and you are considering selling, run the three-layer calculation before listing the property. The recapture on the 1245 components is fixed (it equals the bonus depreciation claimed, regardless of the sale price), so you can calculate layer 1 today. Layer 2 depends on the holding period (how many years of straight-line depreciation were taken on the building). Layer 3 depends on the expected sale price. Once you have the estimated tax, compare it to the 15% FIRPTA withholding and decide whether the 8288-B application is worth the fee and lead time. Start the ITIN process early if you do not already have one, because both the 8288-B and the 1040-NR require it. For the full operational compliance picture during the hold, read the snowbird Airbnb tax guide. For the ownership structure analysis before the next purchase, read the STR holding structure comparison.

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.