Depreciation Recapture Is the Bill People Forget

Ask an investor what tax they would owe on selling a rental and most will name a capital gains rate. Then the return arrives with a second number attached at 25%, and on a property held fifteen years that number is frequently the larger of the two.

What recapture is

Every year you own a rental, you deduct depreciation against your rental income. Residential property is depreciated over 27.5 years, commercial over 39. It is a real deduction that reduces real tax, every year, whether or not the building actually lost value.

When you sell, the IRS takes that benefit back. The depreciation you claimed is recaptured and taxed, separately from the capital gain, at a maximum rate of 25% under Section 1250.

How large it gets

A $600,000 residential rental with an $80,000 land allocation depreciates the $520,000 building over 27.5 years, at roughly $18,900 a year.

Twenty years in, the recapture bill alone approaches six figures on a fairly ordinary rental, before a dollar of capital gains tax is calculated.

A 1031 exchange defers it too

This is the point most often missed in discussions of whether an exchange is worth the trouble. The deferral covers the whole bill: federal capital gains, the 25% recapture, net investment income tax where the thresholds are met, and state tax.

The deferred depreciation carries into the replacement property, and its basis is reduced accordingly, which means the replacement depreciates from a lower figure. That is the trade: you keep the money now, and your future deductions are smaller.

Cost segregation makes it bigger

Investors who ran a cost segregation study to accelerate depreciation have a larger recapture waiting, and part of it may be Section 1245 property recaptured at ordinary income rates rather than 25%.

That is not an argument against cost segregation. It is an argument for knowing what your recapture position is before you decide whether to exchange or sell, because accelerated depreciation makes exchanging considerably more attractive.

And if you never sell

Under current law, heirs receive a stepped-up basis at death, which can eliminate both the deferred gain and the deferred recapture entirely. That is why serious investors exchange repeatedly rather than once.

It is also a plan that depends on law staying as it is, and it is a conversation for your estate attorney rather than a strategy to adopt from an article.