Depreciation Recapture: What Happens When You Sell

What Is Depreciation Recapture?

Every year you own a rental property, the IRS allows (and expects) you to claim a depreciation deduction that reduces your taxable rental income. When you sell, the IRS claws back that benefit through a tax called depreciation recapture. Under Section 1250, the portion of your gain attributable to depreciation previously taken (or allowed) is taxed at a flat 25% rate, separate from the capital gains rate that applies to the remaining appreciation.

The critical detail most investors miss: the IRS taxes depreciation you were "allowed or allowable," regardless of whether you actually claimed it. If you owned a property for 10 years and never took depreciation deductions, you still owe recapture tax as if you had. Skipping depreciation costs you the annual deductions while still triggering the full recapture bill at sale. There is no scenario where avoiding depreciation saves you money.

How Recapture Is Calculated

To calculate depreciation recapture, you need your adjusted basis and your total depreciation claimed (or allowable). Start with your original purchase price plus capitalized acquisition costs. Add any capital improvements made during ownership. Subtract total depreciation to arrive at your adjusted basis.

For example, suppose you bought a residential rental for $350,000 with a $280,000 depreciable basis (excluding land). Over 12 years, you claimed $122,182 in depreciation ($280,000 / 27.5 x 12). Your adjusted basis is $350,000 minus $122,182 = $227,818. If you sell for $450,000 with $25,000 in selling costs, your net sale price is $425,000 and your total gain is $197,182.

That gain is split into two parts. The depreciation recapture portion is $122,182, taxed at 25% ($30,546 in federal tax). The remaining gain of $75,000 is taxed at your applicable long-term capital gains rate (0%, 15%, or 20%). If you are a high earner, add the 3.8% Net Investment Income Tax to both portions.

Strategies to Defer or Reduce Recapture

A 1031 exchange is the most common way to defer depreciation recapture. By exchanging into a like-kind replacement property under Section 1031, both the capital gains tax and the recapture tax are deferred. The deferred depreciation carries over to the replacement property's basis, so recapture is postponed until a future taxable sale. Many investors chain 1031 exchanges over their lifetime, deferring recapture indefinitely.

An installment sale under Section 453 spreads the gain (including the recapture portion) over the years in which you receive payments. However, the IRS requires that all depreciation recapture be recognized in the year of sale, even if payments are received over multiple years. This limits the effectiveness of installment sales for reducing the recapture tax specifically, though the capital gains portion is spread across the payment period.

Holding the property until death provides the most permanent solution. Under current law, heirs receive a stepped-up basis equal to the property's fair market value at the date of death. This eliminates both the capital gains and the accumulated depreciation recapture. For investors with large portfolios, this "hold and bequeath" strategy can save hundreds of thousands in taxes.

Recapture on Cost Segregation Properties

Investors who used cost segregation to accelerate depreciation face higher recapture amounts because they front-loaded deductions into earlier years. The total recapture is based on all depreciation claimed, including the accelerated portions. If a cost segregation study generated $200,000 in depreciation over five years (compared to $90,909 under standard straight-line over the same period), the recapture at sale reflects the full $200,000.

This does not mean cost segregation is a bad strategy. The time value of money makes early deductions more valuable than later ones. A $200,000 deduction taken over five years is worth more in present-value terms than $200,000 spread over 27.5 years. The investor benefits from the cash flow advantage during ownership, even though the recapture bill at sale is larger. Pairing cost segregation with a 1031 exchange eliminates the near-term recapture concern entirely.

For a broader overview of tax planning for rental property investors, see Tax Planning Strategies for Rental Property Income.