Most investors don't understand that depreciation is owed back when you sell!

[Alan Asriants]

Owning real estate comes with many tax advantages and is a big reason some investors diversify into property. It can be a powerful way to offset W-2 income—especially for high earners and the self-employed. Beyond tax benefits, you’re also building equity and cash flow. These advantages become even more significant if you qualify for Real Estate Professional Status (REPS).

A common assumption is that when you sell a rental, you pay capital gains tax (typically 15–20% depending on your bracket) on the gain after basis. What many don’t realize is that depreciation you’ve claimed over the years is also recaptured at sale. In other words, the IRS taxes the portion of your gain equal to depreciation taken (or allowable) to prevent “double-dipping.”

To clarify:

1. Expenses are not repaid at sale. Routine operating expenses—maintenance, repairs, insurance, property taxes, mortgage interest, etc.—are true costs of doing business. They reduce income in the year incurred and are not “paid back” later.

2. What can you depreciate? Two main buckets: the building itself and capital improvements. Depreciation recognizes that these items wear out over time. For residential rentals, the IRS lets you depreciate the building (not land) over 27.5 years. Capital improvements (like a new roof) are also depreciated—often over 27.5 years unless a different recovery period applies. (Cost segregation identifies components with shorter lives—e.g., cabinets, appliances—allowing faster write-offs. It’s more work and cost, which is why investors don’t always use it.)

Because land doesn’t depreciate, you first allocate the purchase price between land and building (your example uses 85% to building). For a $400,000 property, that’s $340,000 depreciable. Annual straight-line depreciation is about $12,364 ($340,000 ÷ 27.5). If you add a $27,500 roof, that’s another $1,000/year over 27.5 years.

How this looks at sale (your example):

• Purchase price: $400,000

• Building portion (85%): $340,000

• New roof (capitalized): $27,500

• Hold period: 10 years

• Sale price: $600,000 (ignoring selling costs for simplicity)

Depreciation over 10 years

• Building: $340,000 ÷ 27.5 × 10 = $123,636.36

• Roof: $27,500 ÷ 27.5 × 10 = $10,000.00

• Total accumulated depreciation: $133,636.36

Adjusted basis at sale

• Initial basis: $400,000 + $27,500 = $427,500

• Less accumulated depreciation: $133,636.36

• Adjusted basis: $293,863.64

Gain (ignoring selling costs)

• Amount realized: $600,000

• Gain: 600,000 − 293,863.64 = $306,136.36

Tax character split

• Depreciation recapture (unrecaptured §1250): $133,636.36 → taxed up to 25% ≈ $33,409

• Remaining LTCG: 306,136.36 − 133,636.36 = $172,500.00 → taxed at your LTCG rate (0/15/20%). Using 15% for simplicity ≈ $25,875

Total federal tax in this simplified example: ≈ $59,284

The key point: depreciation doesn’t vanish. The IRS taxes the portion of gain equal to your depreciation at up to 25% (federal), and the rest at capital-gains rates. Many sellers assume a $200,000 gain (from $400k to $600k) taxed at 15% would be $30,000. In reality, once you factor in depreciation recapture, the tax can be closer to double that simple estimate.

That said, during your 10 years of ownership you benefited from substantial annual tax savings via depreciation. (Mid-month convention, selling costs, state taxes, NIIT, and 1031 exchanges can change the numbers.)

I am not a CPA. For exact treatment in your situation, consult a qualified tax professional.