Depreciation Recapture

Depreciation recapture is the portion of the tax bill on a real estate sale attributable to the depreciation deductions the owner claimed during the holding period. Owners of investment real estate deduct depreciation each year, which lowers taxable income but also reduces the property's adjusted basis, increasing the eventual gain on sale. When the property is sold, the IRS "recaptures" the benefit of those deductions by taxing the depreciation-related portion of the gain at a special rate. For real property, this is the unrecaptured Section 1250 gain, taxed at a maximum federal rate of 25%, which is higher than the long-term capital gains rate that applies to the remaining appreciation. Depreciation recapture can be a significant and often underestimated cost, especially for properties held many years or those that used cost segregation to accelerate deductions. A properly structured 1031 exchange defers depreciation recapture along with the capital gain, because the gain, including the recapture component, carries forward into the replacement property's basis. If an investor receives boot in an exchange, recognized gain may first be characterized as depreciation recapture and taxed at the higher rate. The 3.8% net investment income tax can also apply on top of recapture for higher-income taxpayers.