Depreciation Recapture Explained

Every year an investor owns a depreciable rental property, the tax code allows a deduction for the wear and use of the building, reducing taxable rental income. That deduction also reduces the property adjusted basis. When the property is eventually sold, the portion of the gain that corresponds to depreciation already claimed is recaptured and taxed under its own rules, separate from the standard capital gains treatment that applies to the remaining appreciation.

Why Depreciation Reduces Basis

Depreciation is a non-cash deduction that reflects the theoretical decline in a building value over its useful life, even though many properties in the Washington DC metro area actually appreciate in market value during the same period. Because the deduction reduces adjusted basis each year, a long-held property often carries a much lower basis than its original purchase price, which increases the taxable gain at sale beyond what market appreciation alone would produce.

Section 1250 Property and Unrecaptured Gain

Residential and commercial buildings are generally classified as Section 1250 property under the Internal Revenue Code. When such a building is sold at a gain, the depreciation-related portion is taxed as unrecaptured Section 1250 gain, subject to a maximum federal rate of twenty-five percent. This rate is higher than the top long-term capital gains rate of twenty percent that applies to the remaining, non-depreciation portion of the gain.

Calculating the Recapture Amount

Consider an illustrative example only, not tied to any specific property or transaction. An investor purchases a commercial building for $1,000,000 and claims $300,000 of depreciation over the holding period, reducing the adjusted basis to $700,000. The investor later sells the property for $1,200,000. The total gain is $500,000, calculated as the sale price minus the adjusted basis. Of that $500,000, $300,000 is unrecaptured Section 1250 gain taxed at up to twenty-five percent federally, and the remaining $200,000 is standard long-term capital gain taxed at the applicable capital gains rate.

Depreciation Recapture Is Not the Same as Ordinary Income Recapture

Personal property depreciated under accelerated methods can trigger Section 1245 recapture, taxed at ordinary income rates rather than the twenty-five percent maximum applicable to real property. Since the Tax Cuts and Jobs Act limited Section 1031 to real property, most 1031 exchange investors are dealing primarily with Section 1250 real property recapture, though cost segregation studies that reclassify portions of a building as personal property can introduce Section 1245 considerations that should be reviewed with a tax advisor.

How a 1031 Exchange Defers Depreciation Recapture

A properly structured 1031 exchange defers the entire gain, including the depreciation recapture portion, not just the standard capital gains portion. The recaptured depreciation is not eliminated. It carries forward into the replacement property basis, and if the replacement property is eventually sold outside of another exchange, the original recapture amount, along with any additional depreciation claimed on the replacement property, becomes taxable at that time.

• Recapture is deferred, not eliminated, in a qualifying 1031 exchange
• Deferred recapture carries forward into the replacement property adjusted basis
• A subsequent exchange can defer the same recapture amount again
• Only a sale outside of a 1031 exchange, or the investor eventual death, resolves the deferred recapture

The Step-Up at Death Eliminates Deferred Recapture

One reason investors in the DC metro area use a strategy sometimes summarized as swap until you drop is that the stepped-up basis rule at death resets the property basis to fair market value, which can eliminate previously deferred depreciation recapture along with the deferred capital gain, provided the property is still held by the investor, or passes through the investor estate, at the time of death rather than being sold beforehand.

District of Columbia Treatment of Recaptured Depreciation

The District of Columbia does not apply a separate rate to depreciation recapture. Recognized recapture income is added to the investor total taxable income and taxed under the District graduated brackets, reaching 10.75 percent for taxable income above $1,000,000, in addition to the federal twenty-five percent maximum rate on the recapture portion.

Reviewing Depreciation Records Before a Sale

Because the recapture calculation depends on the exact amount of depreciation claimed over the entire holding period, investors should review their depreciation schedules with a tax preparer well before listing a property, particularly if the property changed hands through a prior exchange, a cost segregation study was performed, or bonus depreciation was claimed in earlier years. Errors or gaps in the depreciation record can complicate the recapture calculation at the least convenient time, during the closing process.

Frequently Asked Questions

Is depreciation recapture the same tax as capital gains tax?

No. Depreciation recapture is a distinct calculation, taxed at a maximum federal rate of twenty-five percent for real property, separate from the standard long-term capital gains rates that apply to the remaining, non-depreciation portion of a gain.

Does a 1031 exchange eliminate depreciation recapture?

No. A qualifying exchange defers the recapture along with the capital gain. Both amounts carry forward into the replacement property basis and become taxable if the replacement property is later sold outside of another exchange.

Does raw land generate depreciation recapture when sold?

No. Raw land is not depreciable, so a sale of unimproved land does not produce depreciation recapture, only standard capital gains treatment on any appreciation.

This article provides educational content only. It does not constitute tax, legal, or investment advice. Section 1031 defers federal income tax on qualifying real property and does not remove Washington DC transfer or recordation tax obligations. Consult a qualified tax advisor or attorney before acting on any exchange timeline.