Depreciation recapture for investors

Investors in real estate and other depreciable property face depreciation recapture tax: when you sell a property, you must “recapture” (pay back) tax on the depreciation deductions you took. The portion of the gain attributable to depreciation is taxed at ordinary income tax rates (up to 25% federally for real estate), not the preferential 0%-20% long-term capital gains rates. This recapture can significantly reduce the after-tax proceeds from a rental property sale.

How recapture works

Suppose you buy a rental house for $400,000 (land $80,000, building $320,000). Over 27.5 years, you depreciate the building at about $11,636 per year. After 10 years, you have taken $116,360 in depreciation deductions.

You sell the house for $500,000. Your original cost basis is $400,000. Your adjusted basis (after depreciation) is $400,000 - $116,360 = $283,640. Your total gain is $500,000 - $283,640 = $216,360.

That $216,360 gain breaks down as:

• Depreciation recapture: $116,360 (the deductions you took), taxed at 25% = $29,090 tax
• Remaining gain: $100,000 (appreciation beyond depreciation), taxed at long-term capital gains rates = $0-$20,000 tax (depending on your bracket)

The recapture amount is taxed at 25% federal (for real estate), which is higher than most long-term capital gains rates.

Why recapture exists

Depreciation deductions reduced your taxable income (and tax bill) every year you owned the property. Recapture ensures you pay tax on those deductions eventually. Without recapture, depreciation would be a permanent tax deferral—you would reduce your tax basis with deductions that you never have to repay. Congress did not allow that.

Section 1245 vs. Section 1250

The recapture rate depends on the type of property:

Section 1245 property: Equipment, machinery, vehicles, and furniture. Depreciation is “straight line” over relatively short lives (5-20 years). Recapture on 1245 property is at ordinary income rates (up to 37% federally).

Section 1250 property: Real estate buildings. Depreciation is straight-line over 27.5 years (residential) or 39 years (commercial). Recapture on 1250 property is at 25% federal (for residential real estate) or ordinary rates if accelerated depreciation was used.

For most investors, the issue is real estate (1250) at a 25% rate.

The land never recaptures

Land does not depreciate (except in rare circumstances). So the portion of your purchase price allocated to land is never subject to recapture. If you bought a house for $400,000 (land $80,000, building $320,000), only the $320,000 building portion can be depreciated and recaptured. The $80,000 land basis simply carries forward.

Avoiding recapture: 1031 exchange

A 1031-like-kind exchange allows you to sell a rental property and buy a similar property, deferring all tax (including recapture) indefinitely. This is the primary tool investors use to manage recapture tax. However, 1031 exchanges have strict timing and like-kind requirements.

Recapture is deferred, not eliminated. When you eventually sell the replacement property without another 1031 exchange, recapture comes due.

Step-up in basis at death

If a rental property is inherited, the heirs receive a step-up in basis—the basis resets to fair market value at the date of death. All embedded depreciation recapture is erased. This is why holding appreciated rental property until death is often tax-optimal.

See also