What Investors Need to Know About Depreciation Recapture

As a tax professional working closely with real estate investors and business owners, one topic I see often overlooked—or misunderstood—is depreciation recapture. Yet, it can have a significant impact on your tax bill when you sell an asset.

Let’s break it down simply:

What is Depreciation Recapture?

When you own investment property, you likely claim depreciation deductions each year to reduce your taxable income. Depreciation allows you to account for the property's wear and tear, even if the property is actually appreciating in value.

However, when you sell the property, the IRS expects you to "recapture" the depreciation you claimed. This means part of your gain on the sale will be taxed differently—and potentially at a higher rate than you might expect.

How Does It Work?

• The IRS assumes you took full depreciation (whether you did or not).

• The portion of the gain related to depreciation is taxed at a flat 25% rate (or your ordinary income rate, if lower).

• Any remaining gain beyond the depreciation recapture is taxed at capital gains rates (typically 15%-20%).

Example: Suppose you bought a rental property for $500,000. Over time, you claimed $100,000 of depreciation. If you sell the property for $600,000:

• Your adjusted basis is $400,000 ($500,000 – $100,000).

• Your gain is $200,000 ($600,000 – $400,000).

• The first $100,000 (depreciation taken) is subject to recapture tax at up to 25%.

• The remaining $100,000 is taxed at capital gains rates.

Why It Matters

Failing to plan for depreciation recapture can lead to unpleasant tax surprises. That's why strategic tax planning is essential, especially if you:

• Are considering selling a highly appreciated asset.

• Want to explore 1031 exchanges to defer the gain and avoid immediate recapture.

• Need to evaluate the timing of the sale to optimize tax brackets.

Key Takeaways

• Depreciation is a powerful tool for tax savings during ownership.

• Upon sale, depreciation recapture rules apply, impacting your tax liability.

• Proactive tax planning—well ahead of a sale—can help minimize your total taxes owed.

If you're a real estate investor or business owner thinking about selling an asset, now is the time to strategize. A thoughtful plan can make all the difference between a manageable tax bill and an expensive surprise.