Depreciation Recapture: Defined and Explained

Depreciation recapture is an important tax concept that real estate investors and business owners must understand when selling depreciated assets. Understanding how depreciation recapture works, which assets it applies to, and strategies to minimize its impact can help investors make informed decisions and reduce unexpected tax burdens.

What Is Depreciation Recapture?

Depreciation recapture is the IRS’s way of reclaiming tax benefits that investors received from depreciation deductions when they sell an asset for a gain. Since depreciation reduces an asset’s taxable value over time, selling the property for more than its adjusted cost basis triggers a recapture tax.

This tax policy prevents investors from claiming depreciation benefits and then profiting from a sale without accounting for the tax savings they received. Understanding how depreciation recapture works can help investors plan ahead and explore tax strategies, such as 1031 exchanges, to defer or minimize their tax liability.

What Is Depreciation?

Depreciation is a tax benefit that allows real estate investors to gradually write off the cost of an income-generating property over its expected lifespan. Since physical structures deteriorate over time, the IRS provides a way to account for this decline by permitting annual deductions that reduce taxable income. Land does not depreciate, however, as it’s considered a permanent asset.

The IRS assigns different depreciation schedules based on asset type. Residential rental properties are typically depreciated over 27.5 years, while commercial properties follow a 39-year schedule. By spreading out these deductions, investors can lower their taxable income each year, improving cash flow and maximizing the financial advantages of property ownership. In some cases, accelerated deprecation or bonus depreciation is taken on a more rapid schedule.

How Is Depreciation Recapture Taxed?

Instead of being taxed as long-term capital gains, the recaptured amount is taxed as ordinary income (up to the total amount of capital gains). The depreciation recapture tax rate you’ll pay depends on the type of asset being sold:

• Section 1245 property (personal property and equipment): The entire amount of depreciation recapture is taxed at your ordinary income tax rate, which can be as high as 37%, depending on your tax bracket.
• Section 1250 property (real estate): Depreciation recapture on real estate is taxed at ordinary income tax rates, up to a special maximum rate of 25%. However, any depreciation taken above and beyond what the straight-line depreciation would have been, by way of a taxpayer using an accelerated depreciation schedule, is taxed at the full ordinary income tax rate. Then, any capital gains beyond the recaptured depreciation amount is taxed as a capital gain at either 0%, 15%, or 20%, depending on income level.

Since depreciation recapture is taxed differently than capital gains, selling a depreciated asset can lead to a higher tax bill than expected.

How to Calculate Depreciation Recapture

To calculate depreciation recapture, follow these steps:

1. Determine the adjusted cost basis: This is the original purchase price of the asset plus any capital improvements, minus the total accumulated depreciation taken over the years.
2. Calculate the total gain on sale: Subtract the adjusted cost basis from the sale price of the asset.
3. Identify the depreciation recapture amount: The portion of the gain that comes from previously claimed depreciation deductions is subject to recapture tax.
4. Apply the appropriate tax rate: Unrecaptured depreciation on real estate (Section 1250 property) is taxed as ordinary income up to a maximum of 25%. If an accelerated depreciation schedule (such as immediate expensing) was used that results in a higher amount of depreciation than would have been taken under straight-line depreciation, that excess depreciation (or “additional depreciation”) is taxed at the ordinary income rate. For personal property (Section 1245 property) like machinery or equipment, the recaptured amount is taxed at ordinary income rates, which could be higher.

Any remaining gain beyond depreciation recapture is taxed as a capital gain, usually at lower rates. Proper planning can help investors mitigate tax liabilities through strategies like 1031 exchanges or reinvestment in qualifying assets.

Example Calculation for Depreciation Recapture

Looking at an example calculation can often be helpful when understanding depreciation recapture.

Let’s say you purchased a rental property for $300,000 (excluding land) and owned it for 10 years, during which you claimed $10,909 per year in depreciation based on the 27.5-year schedule for residential real estate. You decide to sell the property for $400,000.

Since you've owned the property for 10 years, your total depreciation deductions amount to: $10,909 × 10 = $109,090

1. Calculate adjusted basis: The adjusted basis is the original purchase price minus the total depreciation taken (plus any improvements added, if applicable).  $300,000 − $109,090 = $190,9102.    
2. Determine total gain: Total gain is the selling price minus the adjusted basis. $400,000 − $190,910 = $209,090
3. Identify depreciation recapture amount: The depreciation recapture is the total depreciation taken, which is $109,090. This amount is taxed at a maximum rate of 25%. $109,090 × 0.25 = $27,272.50
4. Determine capital gains tax: The remaining gain after depreciation recapture is taxed as a long-term capital gain. $209,090 − $109,090 = $100,000

This portion is taxed at the capital gains tax rate, which is 0%, 15%, or 20%, depending on your income bracket.

Final Tax Breakdown

• Depreciation recapture tax: $27,272.50
• Capital gains tax (assuming a 15% rate): $100,000 × 15% = $15,000
• Total taxes owed: $42,272.50

How to Report Depreciation Recapture on Your Tax Return

To properly report depreciation recapture on your tax return, you’ll need to complete Form 4797, which is used for reporting the sale of business or investment property. This form helps determine how much of your gain is classified as depreciation recapture versus capital gains. Your tax advisor can assist you in completing the calculations appropriately depending on the type of depreciation at play, and the type of taxpayer. Ensuring accurate reporting helps avoid penalties and ensures compliance with IRS regulations.

How to Avoid Depreciation Recapture

Depreciation recapture can significantly increase your tax burden when selling investment or business property. However, there are strategies to defer, minimize, or eliminate this tax liability. Below are some of the most effective ways to reduce depreciation recapture:

• Utilize a 1031 exchange: By reinvesting the proceeds from the sale of an investment property into another like-kind property, you can defer depreciation recapture and capital gains taxes. This strategy allows your investments to continue growing tax-deferred, but it only applies to real estate, not personal property.
• Time the sale to a lower income year: If you expect to have lower taxable income in the future, delaying the sale can reduce the tax impact of depreciation recapture. Since recaptured depreciation is taxed as ordinary income, selling when you'll be in a lower tax bracket means paying less in taxes.
• Use a charitable remainder trust: Transferring property into a charitable remainder trust allows the trust to sell the asset tax-free, avoiding depreciation recapture. In return, you receive a structured income stream while also supporting a charitable cause.
• Hold the property until death: If you retain ownership of the property until you pass away, your heirs receive a step-up in basis to the property’s fair market value at the time of inheritance. This effectively erases past depreciation deductions, allowing them to sell the asset with no depreciation recapture or capital gains taxes.

Choosing the right strategy depends on your long-term financial goals, tax situation, and investment plans. Consulting with a tax professional can help ensure you maximize your benefits while minimizing potential tax liabilities.

The Final Word on Depreciation Recapture

Depreciation recapture is an important tax consideration for anyone selling investment or business property. While depreciation offers valuable tax savings during ownership, the IRS reclaims part of those benefits when the asset is sold for a gain. Understanding how depreciation recapture is taxed and exploring strategies to minimize its impact can help investors keep more of their profits.

One of the most effective ways to defer depreciation recapture and capital gains taxes is through a 1031 exchange. By reinvesting the proceeds into another like-kind property, you can continue building wealth without an immediate tax hit. If you're considering selling a depreciated asset, consult with the professionals at First American Exchange Company to see if a 1031 exchange is the right strategy for you.