Depreciation is one of the greatest tax benefits in real estate — until you sell. Depreciation recapture is the IRS's mechanism for recovering some of those deductions when you sell a property. Understanding how it works, how much it will cost you, and how to defer or minimize it is essential knowledge for any serious real estate investor.
When you sell investment property, the IRS requires you to recapture (and pay tax on) the depreciation deductions you claimed over your holding period. For residential real estate, this is called Section 1250 unrecaptured gain and is taxed at a maximum 25% federal rate — higher than long-term capital gains rates of 15–20%.
If you owned a rental property for 10 years and claimed $100,000 in depreciation, selling triggers $25,000 in federal tax on the recapture — before any gain above your adjusted basis. State income taxes may apply on top of this. This is why knowing your adjusted basis at all times is important.
Your total gain on sale is split into: (1) depreciation recapture taxed at max 25% federal and (2) capital appreciation taxed at long-term capital gains rates (0%, 15%, or 20% depending on income). Understanding this distinction is critical for accurate after-tax profit calculations.
Depreciation recapture calculations are complex, especially if you've done cost segregation or accelerated depreciation. A CPA specializing in real estate should review your adjusted basis and projected recapture before you sell any investment property. The tax impact on an incorrectly estimated deal can be significant.
Dan White is a licensed Virginia real estate agent at Pearson Smith Realty and founder of FreeDealCalc.com. He has been investing in Northern Virginia real estate for 20+ years.