Depreciation Recapture: What It Is and How to Plan Around It

Quick Insights

• Depreciation reduces your taxable income while you own the property, but it also reduces your tax basis. That can increase your taxable gain when you sell.
• Depreciation associated with the building is generally taxed at a maximum 25% federal rate, while depreciation on equipment and certain cost-segregated components may be recaptured as ordinary income.
• Your basis is reduced by the depreciation you were allowed to take, whether or not you actually claimed it.
• Cost segregation and bonus depreciation can pull more of your future gain into ordinary-income territory, which is a real trade-off and not a reason to avoid them.
• The planning happens before you sign a contract. Once the transaction closes, most of the meaningful planning options are gone.

You bought a small apartment building twelve years ago. You've taken depreciation every year since, and it's been one of the better line items on your tax return, helping you reduce your taxable income year-after-year. Now you have an offer, you run the rough numbers, and something doesn't add up: the tax bill on the sale is noticeably higher than the long-term capital gains rate would suggest.

That gap is what most people call depreciation recapture. It isn't a penalty, but it surprises plenty of property owners who have only ever thought about depreciation as a benefit.

A note on the term before going further. "Depreciation recapture" gets used as an umbrella for anything that happens to depreciation at sale, and that's how we're using it in the title.

Technically, straight-line depreciation on most modern real property produces something the tax code calls unrecaptured Section 1250 gain, which is taxed differently than true recapture. The distinction matters once you start running numbers, and we come back to it below.

What Depreciation Recapture Is

When you own residential rental property, you recover its cost over 27.5 years through depreciation deductions. Nonresidential real property runs over 39 years. Those deductions reduce your taxable rental income each year, which is the point.

They also reduce your basis in the property. Basis is what you have invested for tax purposes — roughly your purchase price, plus improvements, minus depreciation. Every dollar of depreciation you claim drops your basis by a dollar, so when you eventually sell, your gain is larger than the simple difference between what you paid and what you sold it for.

Depreciation recapture is the rule that says the portion of that gain created by depreciation gets taxed differently, and less favorably, than ordinary appreciation.

Here's the shape of it in a simplified example. Land isn't depreciable, so the purchase price has to be split between land and building first. Assume no improvements or selling costs, and assume the sale price is allocated between land and building on the same basis as the purchase:

The owner who assumed the whole $350,000 would be taxed at 15% or 20% is looking at a materially different number once the first $150,000 is carved out. (Gain on the land portion is separate and doesn't carry depreciation exposure.)

The "Allowed or Allowable" Rule

Your basis is reduced by depreciation allowed or allowable: meaning the depreciation you could have taken, regardless of whether you actually claimed it on a return.

Skipping depreciation deductions does not preserve your basis. It gives up the annual deduction and leaves the recapture exposure in place. If you've owned a rental and never depreciated it, that's a problem worth raising with your accountant well before a sale, because there are procedures for correcting a missed or incorrect depreciation method.

Two Different Sets of Rules: Section 1250 and Section 1245

Not all depreciated property is treated the same way at sale, and the distinction drives the rate you pay.

• Section 1250 — Depreciable Real Property. Buildings and their structural components. Because real property under MACRS is depreciated straight-line, there is usually no "excess" depreciation to recapture as ordinary income. Instead, the depreciation-attributable gain becomes what the IRS calls unrecaptured Section 1250 gain, which is taxed at a maximum 25% federal rate. That 25% is a ceiling rather than an automatic flat rate on every dollar — the rate applied is the lesser of 25% or your marginal ordinary rate.
• Section 1245 — Depreciable Personal Property. Equipment, machinery, vehicles, appliances, furniture, and similar assets. Gain up to the total depreciation claimed is recaptured as ordinary income, taxed at your regular rate with no 25% ceiling. This is the rule that matters most, for, say, a dental practice selling its operatory equipment or a construction company disposing of machinery. It also matters a lot to real estate investors, as we’ll discuss next.

Gain above the depreciation-related portion generally receives long-term capital gain treatment. On top of all of it, the 3.8% net investment income tax may apply to higher-income taxpayers. Plus, many states have their own systems that create additional tax liabilities for investors.

Cost Segregation Shifts the Bill to the Back End

Cost segregation studies break a building into components and reclassify eligible portions into shorter recovery periods. Combined with bonus depreciation, the result is much faster deductions in the early years of ownership. For an investor with substantial income to shelter, that acceleration is often worth real money, but the tax savings it produces aren’t true savings: they’re simply deferrals of what you’ll eventually owe.

The trade-off is what happens at sale. When those shorter-lived components are sold, some of the resulting gain may be taxed as ordinary income rather than qualifying for the 25% ceiling that commonly applies to building depreciation.

So an investor who uses cost segregation aggressively can find that a meaningful share of the gain on sale is ordinary income, arriving in a single year, at the top of their bracket.

None of this argues against cost segregation. Deferral has value, and an investor who reinvests the early-year tax savings may well come out ahead. What it argues against is running a cost segregation study without modeling the exit. The two decisions belong in the same conversation.

Four Planning Strategies to Consider Before a Sale

Recapture is mostly a timing and rate problem rather than an avoidance problem. The strategies below influence when you recognize the gain and at what rate — which is usually enough to matter.

1031 Like-Kind Exchanges

A fully qualifying exchange of investment real property for other investment real property can defer the gain, including the depreciation-attributable portion. Like-kind treatment applies only to real property, so equipment and similar assets no longer qualify.

Be aware that cash or non-like-kind property received in the exchange (also called "boot") triggers recognition, and recapture is generally pulled out first. Deferral also carries the old basis forward into the replacement property, so the exposure travels with you. This process can be done repeatedly, from property to property.

Holding Assets Until Death

Property included in an estate generally receives a basis adjustment to fair market value, which can eliminate much or all of the built-in taxable gain, including the depreciation-related portion.

For an older investor with a heavily depreciated portfolio and no pressing need for liquidity, this is frequently the single largest factor in the hold-versus-sell analysis. It also needs to be weighed against estate tax exposure and, more importantly, against whether holding the property still makes sense as an investment.

The idea, in plain terms, is that you pass with a real estate empire and a large amount of your unrecognized built-up gains (perhaps some of which you have deferred for many years through 1031 exchanges). When you pass, your heirs inherit the properties, but not your deferred tax obligations. Depending on the value of your assets, there may be estate taxes to pay, but your years of depreciation are essentially considered settled up.

Installment Sales

Spreading the proceeds over several years can keep you in lower brackets and soften the net investment income tax exposure.

Section 1245 ordinary recapture generally must be reported in the year of sale, even if the sale proceeds arrive later. The remaining eligible gain may be recognized as installment payments are received, but each payment can contain gain subject to different federal rates. A seller with significant ordinary recapture exposure and a small down payment can owe more tax in year one than they collected in cash.

Coordinating Asset Sales With Your Tax Strategy

The year of sale can affect your marginal rates, the 3.8% net investment income tax, and your ability to use capital losses or deductions. The available offsets depend on whether the gain is ordinary income, unrecaptured Section 1250 gain, or another form of capital gain. Work with a tax professional to look at the broader picture and consider all of your income sources.

Owners should also identify any suspended passive activity losses associated with the property. Those losses may become available in a fully taxable sale but generally don't receive the same treatment when the gain is deferred through a 1031 exchange. For an investor sitting on years of suspended losses, that can shift the sell-versus-exchange decision on its own.

Where Revonary Fits In

The number that ultimately matters is what you keep after debt, selling costs and taxes.

The tax figure is the one sellers most often get wrong, because different parts of the same property can be taxed at different rates. Getting it right requires pulling the depreciation schedules, separating building depreciation from depreciation on equipment and reclassified components, applying the right rates, layering in state taxes and the net investment income tax, and then testing the alternatives — sell now, exchange, structure as an installment sale, or hold.

At Revonary, we do that modeling for clients who own rental real estate, medical and dental practices with significant equipment, and closely held businesses. We also work with clients earlier than that, at the point where a cost segregation study or an entity decision is on the table, because that is where the exit math is actually set.

If you're weighing a sale in the next year or two, the useful time to run the numbers is now, before a contract exists and before your options narrow. Contact our team and we'll model what the transaction actually nets you.