What Depreciation Recapture Is and Why It Surprises Property Sellers

What Depreciation Recapture Is and Why It Surprises Property Sellers

A real estate investor takes $90,000 of depreciation deductions over six years on a rental property. The deduction shelters $90,000 of income from tax. The investor feels like they got away with something.

They didn't. The IRS pulls a meaningful chunk of it back when the property sells. That's depreciation recapture.

This piece is a plain-English explainer of what recapture actually is, how the §1250 rules work for real property, and why the "allowed or allowable" language is the line that catches investors who tried to skip the deduction.

The deduction the IRS gives, then takes back

Depreciation is the tax code's way of letting an owner expense the cost of a long-lived asset over time rather than all at once. A residential rental depreciates over 27.5 years under the modified accelerated cost recovery system (MACRS), with straight-line treatment. A commercial property depreciates over 39 years.

Each year of ownership, the depreciation deduction reduces taxable rental income. The deduction also reduces the property's basis — the number the IRS treats as the owner's investment in the property for purposes of computing gain on a future sale.

That's the seed of the surprise. Every dollar of depreciation taken now is a dollar of basis lost later. When the property sells, the lower basis means more taxable gain — and the gain attributable to the depreciation is taxed at a different rate than a normal capital gain.

The §1250 rate that catches sellers off guard

For real property held more than one year, the gain on sale is generally taxed at long-term capital gains rates — 0%, 15%, or 20% depending on income, plus the 3.8% net investment income tax under IRC §1411 for higher-income taxpayers.

The portion of the gain attributable to depreciation that was taken — called "unrecaptured §1250 gain" — is taxed at a maximum rate of 25% under IRC §1(h)(6).

That's higher than the standard long-term capital gains rate. It's also lower than ordinary income, so it's not the worst-case scenario — but it surprises investors who expected the entire gain to be taxed at the 15% or 20% rate.

The math on a typical situation: a property bought for $400K with $300K allocable to the building, depreciated for 10 years at the residential straight-line method. Accumulated depreciation: roughly $109,000. If the property sells for $700K, total gain is $409K (sale minus the depreciation-reduced basis). Of that, $109K is taxed at up to 25% under §1250, and the remaining $300K is taxed at the standard long-term capital gains rate.

The recapture portion alone can add roughly $10,900 in additional federal tax versus treating that slice as a normal capital gain (the 10-point spread between the 25% recapture ceiling and a 15% capital gains rate, applied to $109K) — and the full 25% on the $109K is about $27,000 of tax in its own right, before state tax.

The §1245 rate that catches cost-segregation users

Properties that have undergone a cost segregation study have a different recapture exposure to think about.

A study reclassifies portions of the building into shorter-life personal property — 5-year, 7-year, and 15-year assets — that depreciate faster (and often qualify for bonus depreciation). Those personal-property portions are governed by IRC §1245 at sale, which recaptures depreciation at ordinary income rates — typically higher than the §1250 maximum of 25%.

For a high-bracket investor, §1245 recapture on cost-segregated portions can be taxed at up to 37% federal. That's a meaningful piece of the calculus when modeling whether cost segregation pays off — particularly for shorter-hold properties where the depreciation was front-loaded but the holding period doesn't allow the full benefit to outweigh the recapture exposure.

The "allowed or allowable" rule that surprises sellers

Here's the rule that catches investors who skipped depreciation: the IRS recaptures depreciation that was "allowed or allowable" — meaning whatever was actually taken plus whatever should have been taken.

Under §1250(b) and the long-standing interpretation in Rev. Rul. 90-38, taxpayers who chose not to claim depreciation (maybe to keep current-year income higher, or because they didn't know they should) still have to reduce their basis as if they had taken the deduction.

That means an investor who didn't depreciate a rental property for ten years thinking they were preserving basis is in for an unpleasant surprise. The IRS treats the basis as if depreciation was taken, recaptures the missed depreciation at the §1250 rate, and gives the investor neither the deduction they passed up nor the basis they thought they were preserving.

The rule has a fix: a taxpayer who failed to take depreciation in prior years can generally catch up by filing Form 3115 (Application for Change in Accounting Method), claiming the missed depreciation as a §481(a) adjustment in the current year. That recovers the deduction. The basis adjustment happens either way.

What can defer or eliminate recapture

Two structures can deal with recapture exposure:

• A §1031 like-kind exchange defers both the underlying gain and the recapture by rolling the basis (and the deferred gain) into the replacement property. Recapture is deferred along with the rest until a future taxable sale.
• Holding to death under the step-up in basis rules of IRC §1014 generally eliminates recapture (and the rest of the gain) at the estate level, because the heirs receive the property at its fair market value at death. The deferred depreciation effectively never gets recaptured.

A straight sale without either of these structures triggers full recapture.

What planning around recapture actually looks like

Recapture is predictable. The IRS isn't ambushing anyone. The recapture liability is calculable from the depreciation schedule the day after the property is bought.

OLarry builds the recapture model for real estate clients as part of the original acquisition planning — so the exit math is visible from day one rather than discovered at sale.

For investors planning a hold-to-sell strategy (rather than hold-to-death or hold-to-exchange), the recapture is a real cost that has to be factored into the IRR calculation. Cost segregation amplifies the upside in early years but also amplifies the recapture exposure at sale.

Find a CPA who models recapture before the sale

If your real estate CPA has never run a recapture calculation alongside your depreciation schedule, the exit math is incomplete.

OLarry works with real estate investors on depreciation strategy, cost segregation analysis, and the exit modeling that accounts for §1250 and §1245 recapture from day one. Read their Sam's List reviews and book an intro call before the next sale puts the recapture math on the return.