Depreciation feels like free cash flow while you own the property. At sale, the IRS takes a cut of those deductions back. Understanding how recapture works is what keeps the closing statement from surprising you.

What is depreciation recapture?

Depreciation recapture is the IRS taxing the depreciation you claimed while you owned the property. It applies to residential rental property, commercial property, and land improvements. Those past deductions come back into the gain calculation, which often reduces what you net after tax.

How depreciation works

Real estate depreciation follows specific IRS schedules. Residential rental properties use a 27.5 year schedule under Sec. 168. Commercial properties use a 39 year schedule.

Say you buy a residential rental for $275,000 and allocate $225,000 to the building. Land does not depreciate. Annual depreciation is $225,000 divided by 27.5, or roughly $8,182 per year. After 5 years you have claimed $40,910. That total has to be accounted for when you sell.

What happens at sale?

Unrecaptured Section 1250 gain is taxed at up to 25% federal, or at your ordinary rate if that's lower. The remaining gain is taxed at your long-term capital gains rate, usually 15% or 20%. Many investors also owe the 3.8% net investment income tax, and California taxes all of it as ordinary income.

Calculation example

You sell for $300,000. Original purchase price: $275,000. Depreciation already claimed: $40,910. Adjusted basis is $234,090 ($275,000 minus $40,910). Total capital gain is $300,000 minus $234,090, or $65,910.

Recapture tax on $40,910 at 25% is $10,227.50. Only the remaining $25,000 of gain ($65,910 minus $40,910) is taxed at 15%, which is $3,750. Total federal tax: $13,978. (This excludes the 3.8% Net Investment Income Tax and California tax, which add to the bill.)

Strategies that can reduce the hit

  • 1031 exchange. Sec. 1031 lets you defer capital gains tax by reinvesting into replacement property if you meet the requirements.
  • Hold long-term. Property held over 1 year can qualify for long-term capital gains rates on the non-recapture portion of the gain.
  • Cost segregation studies. These accelerate depreciation during ownership. That changes the timing of deductions and how recapture shows up later. It does not erase the recapture concept.
  • Offset gains with losses. Capital losses from other investments can reduce overall tax on the sale.

Key takeaways

Rules under Sec. 1245 and Sec. 1250 shape what you keep at exit. Plan the sale with adjusted basis and depreciation taken in hand, not after escrow closes.

If you are pricing an exit on a rental or commercial property, bring the purchase allocation, depreciation schedules, and a draft sale price and we can walk the tax on paper before you list.