Depreciation Recapture Tax Explained

Depreciation recapture tax catches a lot of first-time sellers off guard, because it is a separate calculation from ordinary capital gains and it applies even to owners who never gave much thought to the depreciation deductions they took, or were entitled to take, over the years they held a Newport Beach rental or commercial property.

Depreciation deductions reduce taxable income each year an investment property is held, on the theory that the building's value declines over its useful life for tax purposes, even if the actual market value is rising. When the property is sold, the IRS recaptures that benefit by taxing the portion of the gain equal to depreciation taken, on the reasoning that the deductions reduced the property's basis and therefore increased the taxable gain at sale.

For residential rental real estate, depreciation recapture is generally taxed at a maximum rate of 25% on the portion of gain attributable to depreciation, sometimes called unrecaptured Section 1250 gain. The remaining gain above the recaptured amount is taxed at ordinary long-term capital gains rates. For example, if an owner's basis was reduced by $150,000 through depreciation over the holding period, that $150,000 portion of the gain is taxed at the 25% recapture rate, separate from whatever rate applies to the rest of the appreciation.

Personal property components within a commercial building, when cost segregation has been used to depreciate them faster than the building itself, can be recaptured at ordinary income rates rather than the 25% rate, which is a distinction worth confirming with a tax advisor on any property where cost segregation was applied.

A common misconception is that skipping depreciation deductions avoids recapture at sale. In most cases it does not. The IRS calculates recapture based on the depreciation that was allowed under the tax code, whether or not the owner actually claimed it on a return. An owner who never took depreciation on a Newport Beach rental still generally faces recapture calculated as if the deductions had been taken, which means skipping the deduction only forfeits the benefit without avoiding the later tax.

A properly structured 1031 exchange defers depreciation recapture along with the capital gains portion of the sale, carrying both forward into the replacement property's basis rather than triggering tax at the relinquished property's closing. This is one of the more overlooked benefits of exchanging rather than selling outright on a property with substantial accumulated depreciation, since the recapture bill alone can represent a meaningful chunk of the total tax otherwise due.

An owner of a Newport Center medical office suite or a small Orange County retail building that has been depreciated for a full 27.5 or 39-year schedule often finds that recapture, not the appreciation itself, is the larger piece of the total tax exposure. That is the calculation worth running with a tax advisor before deciding whether to sell outright or exchange into another property.

Because the recapture calculation depends on the full depreciation history of a property, not just the most recent depreciation schedule, an owner planning a sale should pull the complete depreciation record, including any prior cost segregation study, well before signing a listing agreement. A CPA can typically produce a reasonably accurate estimate of both the recapture amount and the remaining capital gain from that record, which then feeds directly into the decision about whether an exchange, an installment sale, or an outright sale makes the most sense for that particular property.