Selling Business Real Estate: Capital Gains, Depreciation Recapture, and 1031 Exchange

By Yarik Yarosh, CPA ·September 5, 2026 ·6 min read

Written by Yarik Yarosh, CPA (US & Canada) September 5, 2026 · FL CPA license AC61704 · CPA Ontario

Selling business real estate triggers a two-layer tax: depreciation recapture (the gain attributable to previously claimed depreciation, taxed at 25% as “unrecaptured Section 1250 gain”) and capital gain on any appreciation above the original cost (taxed at 0%, 15%, or 20% depending on income). The 1031 like-kind exchange under IRC 1031 allows the seller to defer BOTH layers of tax by reinvesting the net proceeds into replacement real property of equal or greater value. The TCJA (2018) limited 1031 exchanges to real property only; exchanges of equipment, vehicles, machinery, and other personal property are no longer permitted. The exchange must follow strict timelines: the replacement property must be identified within 45 days and acquired within 180 days of the sale. All proceeds must be held by a qualified intermediary (the seller can’t touch the funds).

✓Key takeaway

Tax components when selling business real estate:

Component	Tax Rate	What It Covers
Depreciation recapture (unrecaptured Section 1250 gain)	25%	Gain up to total depreciation claimed on the property
Long-term capital gain	0%, 15%, or 20% (income-based)	Gain above original cost basis
Net investment income tax (NIIT)	3.8%	Applies if MAGI exceeds $200K single / $250K MFJ
State income tax	Varies	Many states don’t have a separate capital gains rate

1031 like-kind exchange requirements:

Requirement	Details
Property type	Real property exchanged for real property (since TCJA)
Held for business/investment	Both relinquished and replacement property must be held for business use or investment (not personal residence)
Identification period	45 calendar days from sale to identify replacement property
Exchange period	180 calendar days from sale to close on replacement property
Qualified intermediary (QI)	Required; seller can’t receive or control proceeds
Equal or greater value	Replacement must be equal or greater value to defer 100% of gain
Boot	Any cash or non-like-kind property received (boot) is taxable

1031 identification rules:

Rule	Details
Three-property rule	Identify up to 3 properties (any value)
200% rule	Identify any number of properties if total FMV doesn’t exceed 200% of relinquished property
95% rule	Identify any number if 95%+ of identified value is actually acquired

What qualifies as like-kind real property:

Relinquished Property	Replacement Property	Like-Kind?
Office building	Apartment complex	Yes
Vacant land	Warehouse	Yes
Retail strip center	Single-family rental	Yes
Commercial building	Undeveloped land	Yes
US real property	Foreign real property	No (since TCJA)
Real property	Equipment or vehicles	No (since TCJA)

How does the tax work when selling a business property?

Hypothetical example

Round numbers. A business owner sells a commercial building used in their S-Corp operations.

Property details:

Item	Amount
Original purchase price	$500,000
Land allocation (not depreciable)	$100,000
Building cost (depreciable)	$400,000
Years owned	15 years
Annual depreciation (39-year commercial, straight-line)	$10,256/year
Total depreciation claimed	$153,846
Adjusted basis (building)	$400,000 - $153,846 = $246,154
Adjusted basis (total, with land)	$246,154 + $100,000 = $346,154
Sale price	$750,000

Tax calculation on straight sale (no 1031 exchange):

Component	Calculation	Amount
Total gain	$750,000 - $346,154	$403,846
Depreciation recapture (Section 1250)	Lesser of total gain or total depreciation ($153,846)	$153,846
Remaining capital gain	$403,846 - $153,846	$250,000

Tax	Rate	Amount
Depreciation recapture tax	25%	$38,462
Capital gains tax	20%	$50,000
NIIT	3.8% on total gain	$15,346
State tax (6% example)	6% on total gain	$24,231
Total tax on sale		$128,039

After-tax proceeds: $750,000 - $128,039 = $621,961

1031 exchange (defer all taxes):

Step	Action	Deadline
1	Sell the commercial building for $750,000	Day 0
2	Proceeds go to qualified intermediary (not the seller)	Day 0
3	Identify replacement property (up to 3 properties)	By Day 45
4	Close on replacement property	By Day 180
5	Use all $750,000 in proceeds toward the purchase	At closing

Replacement property purchased: $800,000 warehouse

Item	Amount
Purchase price	$800,000
Exchange proceeds applied	$750,000
Additional cash from buyer	$50,000
Mortgage on new property	$0
Boot received	$0 (all proceeds reinvested)
Tax deferred	$128,039

The owner now owns an $800,000 warehouse with a carryover basis of $346,154 + $50,000 new cash = $396,154. The deferred gain carries over to the replacement property. If the warehouse is later sold for $900,000 without another 1031 exchange, the deferred gain plus new gain will be taxable.

Partial exchange (boot): If the replacement property costs only $600,000:

Item	Amount
Sale proceeds	$750,000
Replacement property	$600,000
Cash back to seller (boot)	$150,000
Taxable boot	$150,000 (taxed as gain, depreciation recapture first)
Deferred gain	$253,846

The $150,000 in boot is taxable, with the depreciation recapture portion taxed at 25% first, then the remainder as capital gain.

Installment sale alternative: If no replacement property is available, the seller can structure an installment sale (IRC 453) to spread the gain over multiple years.

Term	Details
Sale price	$750,000
Down payment	$150,000 (Year 1)
Remaining balance	$600,000 over 10 years ($60,000/year + interest)
Gross profit percentage	$403,846 / $750,000 = 53.85%

Year	Payment	Taxable Gain (53.85%)	Tax (approximate)
Year 1	$150,000	$80,775	$24,000
Years 2-11	$60,000/year	$32,310/year	$9,700/year

Important: depreciation recapture ($153,846) is taxed IN FULL in Year 1 regardless of the installment terms. Only the capital gain portion is spread over the installment period.

Year 1 tax with installment sale:

Component	Amount
Depreciation recapture (all in Year 1)	$153,846 x 25% = $38,462
Capital gain portion of $150,000 payment	$80,775 - portion allocated to recapture
Year 1 payment gain	Approximately $80,775

The installment sale defers capital gains but not depreciation recapture. A 1031 exchange defers both.

Illustrative numbers only, not a real client and not advice for your facts.

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Cite this page

Yarik Yarosh, CPA. "Selling Business Real Estate: Capital Gains, Depreciation Recapture, and 1031 Exchange." Blue Cloud CPA, September 5, 2026. https://bluecloudcpa.com/guides/small-business-tax-implications-selling-commercial-real-estate

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