Depreciation Recapture: The Tax You Pay When You Sell

What Is Depreciation Recapture?

When you own rental property, the IRS lets you deduct depreciation each year, reducing your taxable income. When you sell, the IRS wants some of that benefit back. Depreciation recapture is the tax on the depreciation you previously deducted.

For real estate, depreciation recapture falls under Section 1250 (unrecaptured Section 1250 gain). The maximum tax rate is 25%, which is higher than the 15-20% long-term capital gains rate but lower than ordinary income rates.

Important: recapture applies to depreciation "allowed or allowable." If you owned a rental for 10 years and never claimed depreciation, the IRS still calculates recapture as if you did. Never skip depreciation deductions.

How It Is Calculated

The gain on sale is split into two layers:

Layer 1: Depreciation Recapture (Up to 25%)

The total depreciation taken during ownership is recaptured at up to 25%. This portion of the gain represents the "payback" of prior depreciation deductions.

Layer 2: Capital Gain (15% or 20%)

Any gain above the original purchase price is taxed at long-term capital gains rates.

Example

Cost Segregation Interaction

A common concern: does cost segregation increase my recapture liability? The answer is nuanced.

Cost seg does not change the total depreciation allowed over the property's life. It reclassifies when you take it. You claim more depreciation upfront and less later. At sale, the total recapture amount is the same whether you did a cost seg study or not (assuming you hold the property long enough).

However, if you sell early, cost seg means you have taken more cumulative depreciation at that point, so your recapture amount is larger. The trade-off: you received the tax benefit years earlier. The time value of that money, invested or deployed, almost always exceeds the additional recapture.

Avoidance and Deferral Strategies

You cannot eliminate recapture on a taxable sale, but you have several deferral and mitigation options:

1031 Exchange

The most powerful tool. A like-kind exchange defers both capital gains and depreciation recapture into the replacement property. You can exchange repeatedly throughout your lifetime, deferring indefinitely.

Stepped-Up Basis at Death

When you die, your heirs receive the property at its current fair market value (stepped-up basis). All deferred depreciation recapture and capital gains are eliminated. This is why the "buy, depreciate, exchange, die" strategy exists.

Installment Sale

Selling on an installment note spreads the gain (including recapture) over the payment period. This can keep you in lower tax brackets each year. However, depreciation recapture is recognized in the year of sale up to the amount of payments received, so it is partially front-loaded.

Charitable Remainder Trust

Contributing property to a CRT before sale avoids immediate recognition of gain. The trust sells the property and reinvests. You receive income payments, and the charity receives the remainder. Complex but effective for large gains.

Opportunity Zone Investment

Reinvesting capital gains (not recapture) into a Qualified Opportunity Zone Fund can defer and partially reduce capital gains tax. Depreciation recapture is not eligible for OZ deferral, but the capital gains portion is.