When you sell a rental, the depreciation you took (or were entitled to take) reduces your basis, which increases your gain. The part of the gain from depreciation on the building is taxed at up to 25%, and the rest is taxed at regular long-term capital gains rates. A 1031 exchange can defer both.
- Depreciation lowers your basis, which raises your gain when you sell.
- Gain from depreciation on the building is taxed at a maximum rate of 25%.
- Depreciation on cost segregation components is generally recaptured as ordinary income.
- A 1031 exchange defers both the capital gain and the recapture.
How Does Depreciation Recapture Work?
Every year you own a rental, depreciation lowers your taxable income. It also lowers your adjusted basis in the property. When you sell, your gain is the sale price minus selling costs minus that adjusted basis, so the depreciation shows up again as extra gain.
What Does Recapture Look Like With Real Numbers?
You buy a rental for $400,000, with $80,000 allocated to land. The $320,000 building is depreciated over 27.5 years, about $11,600 a year. After five years, you've taken about $58,000 of depreciation. You sell for $500,000. To keep it simple, ignore selling costs and improvements.
| Sale price | $500,000 |
| Original cost | $400,000 |
| Less depreciation taken | −$58,000 |
| Adjusted basis | $342,000 |
| Total gain | $158,000 |
Of that $158,000:
- $58,000 is "unrecaptured Section 1250 gain," taxed at a maximum rate of 25%.
- $100,000 is regular long-term capital gain, taxed at 0%, 15% or 20% depending on your income.
Higher-income sellers may also owe the 3.8% net investment income tax, and state income tax usually applies too.
How Does Cost Segregation Affect Recapture?
Components depreciated over 5, 7 or 15 years are generally Section 1245 property. Depreciation on those is recaptured as ordinary income, which can be taxed at higher rates than 25%. That's one reason to plan the sale, not just the purchase, when you accelerate depreciation.
How Can I Reduce or Defer Recapture?
- A 1031 exchange defers both the capital gain and the recapture into the replacement property.
- Timing. Selling in a lower-income year can reduce the rate on the capital gain portion.
- Suspended passive losses. Losses you couldn't use while you owned the property are generally released when you sell it in a fully taxable sale, which can offset some of the gain.
- Holding long term. Under current law, heirs who inherit property generally receive a stepped-up basis, which can wipe out the deferred gain and recapture.
Skipping depreciation doesn't avoid recapture. Your basis is reduced by depreciation you were entitled to take, whether or not you took it. More on that in the depreciation guide.
Quick Questions
Can I avoid depreciation recapture by not claiming depreciation?
No. The basis reduction applies to depreciation that was allowed or allowable, so not claiming it means losing the deduction and still facing recapture.
Is depreciation recapture always taxed at 25%?
For depreciation on the building itself, 25% is the maximum rate, and it can be lower if your ordinary rate is lower. Depreciation on shorter-lived components from cost segregation is recaptured as ordinary income.