Depreciation Recapture: The Tax Bill That Surprises Landlords at Sale

Depreciation is one of the best perks of owning rental property, but it comes with a catch that surprises a lot of landlords at the closing table: depreciation recapture. Here is what it is, how much it costs, and how to avoid or defer it.

What recapture is

Every year you own a rental, you deduct depreciation, which lowers your taxable income. But those deductions also lower your cost basis in the property. When you sell, the IRS recaptures the depreciation you took by taxing the portion of your gain that came from those deductions.

The recapture rate on real estate is the unrecaptured Section 1250 rate, capped at 25 percent, which is often higher than the long-term capital gains rate on the rest of your gain.

A simple example

Suppose you bought a rental for 400,000 dollars, with a 320,000 dollar building basis, and held it 10 years. At roughly 11,600 dollars of depreciation a year, you took about 116,000 dollars of depreciation. When you sell, that 116,000 dollars is subject to recapture at up to 25 percent, roughly a 29,000 dollar tax bill, on top of capital gains on your appreciation. The depreciation calculator estimates both your annual depreciation and the recapture you would owe at sale.

You cannot skip it by skipping depreciation

A common misconception is that you can avoid recapture by simply not taking depreciation. You cannot. The IRS recaptures depreciation allowed or allowable, meaning you owe recapture on the depreciation you could have taken, whether or not you actually claimed it. So you should always take it.

Why cost segregation raises the stakes

If you used cost segregation to accelerate depreciation, you took more deductions sooner, which means a larger recapture exposure at sale. That is fine, as long as you plan for it.

How to defer it

The cleanest way to avoid paying recapture is to not sell outright. A 1031 exchange rolls your proceeds into another investment property and defers both the recapture and the capital gain. Many investors exchange up for decades and never trigger the bill.

Bottom line

Recapture is not a reason to avoid depreciation, it is a reason to plan your exit. Estimate your exposure with the tax tools, and decide whether a 1031 exchange makes sense before you list.