Navigating Depreciation Recapture in Real Estate Transactions
What Investors Need to Know About Depreciation, Tax Rates, and Section 1250 Property
When selling a real estate investment, one of the most misunderstood tax consequences is depreciation recapture. Many investors are familiar with capital gains tax, but fewer realize that part of their gain may be taxed differently due to depreciation claimed during ownership. Understanding how this works is critical—especially for those considering a 1031 Exchange, where careful planning can help defer both capital gains and depreciation recapture.
Understanding Depreciation on Investment Properties
Depreciation is a tax deduction that allows real estate investors to recover the cost of an income-producing property over time. For residential rental properties, the IRS allows depreciation over 27.5 years, and for commercial properties, over 39 years. While land itself is not depreciable, the value assigned to the building or improvements can be written off annually, reducing the property’s taxable income during the holding period.
Depreciation provides a powerful tax benefit while holding the property—but it also creates a hidden tax liability when the property is sold.
What Is Depreciation Recapture?
Depreciation recapture is the process by which the IRS “recoups” some of the tax benefits previously claimed through depreciation. When you sell the property, the portion of the gain attributable to depreciation is taxed at a different rate than regular capital gains.
This means that even if the property appreciates significantly, the IRS will separate the profit into two parts:
The capital gain (typically taxed at 15% or 20%)
The recaptured depreciation, which is taxed at a maximum rate of 25%
Even if you didn’t actually take depreciation deductions, the IRS treats the property as if you did—this is known as allowed or allowable depreciation—so the recapture rule still applies.
How Tax Rates Apply in a Sale
Let’s say you purchased a rental property for $500,000 and over the years, you claimed $100,000 in depreciation. You then sell the property for $700,000. Your total gain is $300,000:
The $100,000 in depreciation is subject to depreciation recapture tax (up to 25%)
The remaining $200,000 is considered a long-term capital gain (typically taxed at 15% or 20%, depending on your income bracket)
The recaptured amount is not a penalty; it simply adjusts your taxable gain to reflect the prior depreciation benefit. However, it can significantly impact your tax bill if you're not expecting it.
Section 1250 Property and Its Tax Implications
Most real estate held for investment or business use—such as rental properties—is classified as Section 1250 property under the Internal Revenue Code. Section 1250 governs how gains from the sale of depreciable real property are taxed.
For properties placed in service after 1986 (most modern real estate), straight-line depreciation is generally used. Under Section 1250:
Gains attributable to straight-line depreciation are taxed up to 25%, which is the depreciation recapture rate for real property.
If accelerated depreciation (used more often in older properties) was claimed, the excess over straight-line could be taxed at even higher rates.
Understanding the classification of your property as Section 1250 property is important for forecasting your total tax exposure when planning a sale.
Can Depreciation Recapture Be Deferred in a 1031 Exchange?
Yes. If properly structured, a 1031 Exchange allows investors to defer depreciation recapture—along with capital gains taxes—by reinvesting in like-kind property. However, this deferral is not a permanent elimination of tax. If the replacement property is eventually sold in a taxable transaction, all previously deferred depreciation will be subject to recapture at that time.
The key is that as long as the 1031 Exchange chain continues, the tax deferral continues—making it a powerful long-term wealth-building strategy.
Depreciation can save investors a significant amount in annual taxes, but it also creates a deferred liability that must be addressed when the property is sold. By understanding how depreciation recapture works—particularly with Section 1250 property—and factoring in income tax implications, real estate investors can make better-informed decisions when planning their exit strategies or considering a 1031 Exchange.
If you’re planning to sell or exchange investment property, consult with a tax advisor or Qualified Intermediary to fully understand your potential depreciation recapture liability and how to manage it strategically.
