Depreciation Recapture Example: Explaining the Tax Math

You’ve spent years claiming depreciation deductions on your rental property. Each write-off reduced your taxable income and kept more money in your pocket. Then you sell, and a tax bill shows up that you weren’t expecting. This is depreciation recapture, and it catches many real estate investors off guard. The good news is that once you understand how the calculation works, you can plan for it and potentially reduce the impact.

How Real Estate Depreciation Works

The IRS allows property owners to deduct a portion of their building’s value each year to account for wear and tear. For residential rental properties, you spread the building’s cost over 27.5 years. Commercial properties use a 39-year schedule. Land cannot be depreciated because it does not wear out.

Consider a residential rental purchased for $400,000 where the land is worth $75,000. Your depreciable basis is $325,000 for the building alone. Divide that by 27.5 years and you can deduct approximately $11,818 annually. Over a decade of ownership, those deductions add up significantly.

These deductions directly lower your taxable income from the property each year. If your rental generates $30,000 in net operating income and you claim $11,818 in depreciation, your taxable income drops considerably. That puts real money back in your pocket during each year of ownership.

The important detail is that each depreciation deduction also reduces your adjusted basis in the property. Your original investment shrinks on paper with every deduction you claim. This adjusted basis determines how much of your sale proceeds count as taxable gain when you eventually sell. According to IRS Publication 946, depreciation allowed or allowable must reduce your property’s basis regardless of whether you actually claimed the deduction on your tax returns. That last point surprises many investors who assumed skipping the deduction would help them avoid recapture later.

What Is Depreciation Recapture?

When you sell a depreciated property for more than your adjusted basis, the IRS wants to recover some of the tax benefits you received during ownership. The government views it as balancing the equation. You benefited from those deductions while you owned the property, and now a portion of your gain will be taxed at a higher rate.

For real estate, this recaptured amount is called unrecaptured Section 1250 gain. The maximum federal tax rate on this portion is 25%, as outlined in the Instructions for IRS Form 4797. This rate applies to the lesser of your total gain or your accumulated depreciation. Any gain above the depreciation amount gets taxed at long-term capital gains rates, which are generally lower.

The recapture rules apply whether you claimed depreciation or not. The IRS taxes you on depreciation that was allowable, meaning if you failed to take the deduction, you still owe recapture tax as if you had. This makes accurate record-keeping and proper depreciation claims throughout ownership essential.

A Detailed Depreciation Recapture Example

Let’s work through a calculation to see how this plays out in practice. Assume you purchased a residential rental ten years ago for $400,000. The land was worth $75,000, giving you a depreciable basis of $325,000 for the building.

Over ten years you claimed depreciation deductions totaling roughly $118,000. Your adjusted basis dropped from the original purchase price by that same amount.

You sell the property for $550,000. Your total gain equals the sale price minus your adjusted basis.

Now the gain splits into two categories. The portion equal to your accumulated depreciation is unrecaptured Section 1250 gain taxed at a maximum rate of 25%. The remaining gain above that amount is long-term capital gain taxed at lower rates depending on your income bracket.

Without understanding recapture, you might assume your entire gain would be taxed at the lower capital gains rate. The actual bill runs considerably higher because a substantial chunk faces the 25% recapture rate instead. This surprise has derailed many closing day celebrations.

Cost Segregation And Recapture Considerations

Cost segregation studies allow investors to accelerate depreciation by identifying building components that qualify for shorter depreciation periods. This delivers larger deductions early in ownership but creates different recapture consequences at sale.

Components classified as personal property under Section 1245 face recapture at ordinary income tax rates rather than the 25% cap that applies to Section 1250 real property. If a study reclassified portions of your building and you claimed accelerated depreciation on those amounts, selling triggers recapture at potentially higher ordinary rates on those portions.

This does not make cost segregation a poor strategy. The time value of early deductions often outweighs higher eventual recapture, especially if you hold the property for many years. But investors should understand both sides of the equation before implementing aggressive depreciation approaches.

Options To Reduce Or Defer Recapture

A 1031 like-kind exchange allows you to defer both capital gains and depreciation recapture by reinvesting proceeds into another qualifying property. The deferred depreciation carries over to your replacement property, postponing the tax bill until a future sale.

An installment sale spreads gain recognition over multiple years as you receive payments. This can help manage your tax situation, though the 25% maximum recapture rate still applies to the depreciation portion. It is important to note that the recapture is treated as ordinary income. For example, 1245 recapture is reported in the year of sale, even if using an installment sale.

Holding property until death provides heirs with a stepped-up basis, eliminating both capital gains and depreciation recapture that would have been due during your lifetime. For investors focused on building generational wealth, this approach deserves serious consideration.

Plan Ahead For Your Real Estate Exit

Depreciation recapture is predictable once you understand how accumulated deductions affect your eventual tax bill. Running the numbers before listing your property gives you time to evaluate whether a 1031 exchange, installment sale or another approach makes sense for your situation.

At James Moore, our real estate tax team helps clients understand their recapture exposure and develop strategies to address it. If you’re considering selling investment property, contact a James Moore professional to discuss your options.

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