What is depreciation recapture and how do I plan for it?
Depreciation recapture is the tax the IRS collects when you sell a property for more than its depreciated value. Every year you claim depreciation deductions, you reduce your taxable income. When you sell, the IRS wants a portion of that benefit back.
The depreciation you’ve taken on the building itself is taxed as unrecaptured Section 1250 gain at a maximum rate of 25 percent. If you bought a property for $1 million, claimed $200,000 in depreciation over the years, and sell for $1.2 million, that $200,000 in prior depreciation is subject to recapture at up to 25 percent.
If you had a cost segregation study done, the calculation gets more complicated. Cost segregation reclassifies portions of the property as personal property with shorter depreciation lives. This includes things like appliances, carpeting, fixtures, and land improvements. The accelerated deductions save you money in the early years of ownership. But when you sell, that depreciation on Section 1245 personal property is recaptured as ordinary income at your marginal tax rate. That could be 32, 35, or even 37 percent depending on your income.
The tradeoff is real. Cost segregation provides significant upfront tax savings, but it increases your recapture exposure when you exit. Working with a real estate accounting firm that understands these dynamics can help you weigh the benefits against the eventual recapture before you commit to a strategy.
The most common way to defer recapture is a 1031 exchange. By exchanging into like-kind property, you defer both the capital gain and the depreciation recapture. The tax basis carries over to the new property, which means you’re deferring the tax rather than eliminating it. But for investors who plan to keep exchanging or hold property until death, when heirs receive a stepped-up basis, the deferral can effectively become permanent.
Timing the sale is another planning lever. If you’re in a lower income year, your ordinary income rate on Section 1245 recapture may be lower. If you’re approaching retirement or have losses to offset gains, selling in that year might reduce your overall tax burden.
The key is modeling the tax consequences before you decide to sell. Too many investors get surprised at closing when they realize how much of their proceeds go to recapture taxes. Tax advisory and planning should happen before the sale, not after. Know your exposure, evaluate your options, and make the decision with full visibility into what you’ll owe.
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More Questions
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