Depreciation Recapture: The Tax Hiding Behind Your Sale Price
Most property owners estimate their tax bill by looking at what they paid and what they are selling for. That misses the tax the IRS has been quietly accruing every year you owned the building — and it is often the larger piece.
Ask a long-time landlord what they will owe when they sell, and the answer usually goes like this: I bought it for $1 million, it is worth $2.5 million, so I have $1.5 million of gain, taxed at capital gains rates. That math is intuitive, common, and wrong — sometimes by hundreds of thousands of dollars. The reason is depreciation, and the tax that comes due on it is called recapture.
What depreciation did while you owned the building
Every year you owned an investment property, the tax code let you deduct a portion of the building’s cost as depreciation — for residential rental property, over 27.5 years; for commercial, over 39 years. Those deductions reduced your taxable rental income each year. They also reduced your adjusted basis in the property, dollar for dollar.
Basis is the number gain is measured against. If you bought for $1 million (say $800,000 attributable to the building and $200,000 to land) and held a residential rental for twenty years, you deducted roughly $580,000 of depreciation. Your adjusted basis is no longer $1 million. It is about $420,000. When you sell for $2.5 million, your taxable gain is not $1.5 million. It is closer to $2.08 million — and the $580,000 you depreciated is taxed under its own rules.
How recapture is taxed
The gain attributable to depreciation on real property is treated as “unrecaptured Section 1250 gain” and taxed at a maximum federal rate of 25 percent — higher than the 15 or 20 percent long-term capital gains rate that applies to the appreciation above your original cost. On top of that, the 3.8 percent net investment income tax generally applies to both pieces for higher-income sellers, and most states tax the entire gain as ordinary income. California, for example, does not offer a preferential capital gains rate; its top marginal rate exceeds 13 percent.
Put the layers together on the example above, and the picture changes.
- Appreciation gain (roughly $1.5 million): federal long-term capital gains at up to 20 percent, plus 3.8 percent NIIT, plus state tax.
- Depreciation recapture (roughly $580,000): federal tax at up to 25 percent, plus 3.8 percent NIIT, plus state tax.
For a California seller in the top brackets, the combined federal and state tax on that sale can approach or exceed a third of the total gain — and the recapture portion is the part most owners never saw coming, because it does not appear anywhere on a listing agreement or a closing statement. These figures are illustrative; the actual liability depends on your income, filing status, state of residence, cost segregation history, and other facts your CPA will model.
The listing price shows you appreciation. Your tax return shows you recapture. Only one of them is a surprise.
Why cost segregation makes this larger
Investors who accelerated depreciation — through a cost segregation study or bonus depreciation — deducted more, sooner, and enjoyed lower taxable income in the early years of ownership. The bill for that arrives at sale. Accelerated depreciation on components classified as personal property (Section 1245 property) is recaptured at ordinary income rates, not the 25 percent Section 1250 rate. Cost segregation is often a sound strategy; it is also one that makes the eventual recapture both larger and taxed at higher rates, and sellers who benefited from it should have their CPA model the exit before signing a purchase agreement.
What a 1031 exchange does with recapture
A properly structured Section 1031 exchange defers the entire gain — both the appreciation and the depreciation recapture — provided you acquire replacement property of equal or greater value, reinvest all net equity, and replace the debt. The deferred gain and the accumulated depreciation carry over into your replacement property’s basis, which means the clock does not reset. When the replacement property is eventually sold outside an exchange, everything comes due together.
Three things to understand about how this works in practice.
Deferral is not elimination. The recapture is still there, embedded in a lower carryover basis. Under current law, the only event that eliminates it is death, when heirs receive a stepped-up basis. That is why many investors exchange serially — but it is a strategy that relies on current law remaining in place.
Boot triggers recapture first. If you take cash out of an exchange or fail to replace all of the debt, the resulting taxable “boot” is generally treated as recognizing gain — and the tax code recognizes depreciation recapture before capital gain. A partial exchange therefore tends to trigger the highest-taxed portion of your gain first, which is worth knowing before you decide to pull equity out.
Replacement property keeps depreciating. Your carryover basis continues to depreciate on the original schedule, and the excess basis from a more expensive replacement property starts a new schedule. In a DST, your share of the property’s depreciation flows through to you and continues reducing your basis — so recapture keeps accruing while you defer.
What to do before you list
- Ask your CPA for a projected tax liability that separates appreciation gain from depreciation recapture, at federal and state rates, before you sign a listing agreement.
- If you had a cost segregation study, ask specifically how much of your recapture will be taxed at ordinary income rates.
- Decide whether a full exchange, a partial exchange, or an outright sale fits your goals — with the recapture number in hand, not the appreciation number.
- If exchanging, engage a qualified intermediary before closing; proceeds that touch your hands disqualify the exchange.
- Ask what replacement property — direct, DST, or a mix — lets you replace the value and the debt without taking boot.
The sale price is the number everyone talks about. The recapture is the number that determines whether the sale was worth it. Know both before you decide.
NOTE This article is provided for educational purposes only and does not constitute tax or legal advice. Tax figures are illustrative and simplified; rates and rules are subject to change and vary by taxpayer. Consult your CPA and tax attorney regarding your specific situation. Section 1031 exchanges defer — they do not eliminate — capital gains and depreciation recapture taxes. This article was prepared with the assistance of artificial intelligence tools and reviewed by the author.
Know your real tax number before you sell. We work alongside your CPA to model the exchange-versus-sell decision — recapture included — and to identify replacement property that defers all of it. Call (818) 206-7550 or visit carmonawealth.com.
Our advisory team reviews the whole DST marketplace — and helps investors plan exits as carefully as entries. Meet the team →
Talk It Through With Our Team
Private, no-obligation, and specific to your numbers — not a sales script.
Continue reading
Ready to Go Deeper?
Request access to the private investor portal to see current offerings, or schedule a consultation to map your options.