Depreciation Recapture: What Real Estate Investors Should Know

One of those tax concepts that sounds more complicated than it needs to be.
If you own rental or investment real estate, it allows you to deduct part of the property’s value over time. Those deductions can reduce taxable income and improve cash flow.

When you eventually sell the property, the IRS may require you to pay tax on some of the depreciation you previously claimed. That is depreciation recapture.

How does it work?

Start with your original tax basis in the property. Then subtract the depreciation you have taken over the years. That gives you your adjusted basis.

If you sell the property for more than that adjusted basis, part of the gain may be attributable to depreciation and subject to recapture.

Example: suppose you purchased a rental property for $300,000 and claimed $60,000 of depreciation. Your adjusted basis would be $240,000.
If you later sell the property for $280,000, the $40,000 difference between the sale price and adjusted basis may be subject to recapture.

For real estate, that portion is generally taxed at a maximum federal rate of 25%. Other types of depreciable assets may be treated differently.

Why does the IRS do this?
Depreciation gave you a tax benefit while you owned the property.
Recapture is essentially the IRS accounting for part of that benefit when the property is sold.

That does not mean depreciation was a bad strategy. In many cases, having the use of those tax savings for years can be extremely valuable, especially when that cash is reinvested into additional properties, business growth, or other investments.

Can depreciation recapture be deferred?
Potentially.

One of the most common strategies real estate investors use is a 1031 exchange. When structured properly, a 1031 exchange can allow an investor to defer capital gains taxes and depreciation recapture by moving into another qualifying investment property.

Good recordkeeping is also important. Keep clear records of your original basis, improvements, depreciation schedules, and any major renovations or asset dispositions.
Because the rules can become complicated, especially after a cost segregation study, it is important to coordinate with a knowledgeable tax professional.

What does this mean for cost segregation?
That can create substantial deductions earlier in the ownership period and potentially put more cash back into your hands today.

Yes, some of that depreciation may eventually be subject to recapture if you sell.
Sophisticated tax planning is rarely just about asking, “Will I owe tax later?”

The better question:

What can I do with the tax savings today, and what strategies may be available when I eventually sell?

That is why cost segregation, depreciation recapture, and exit planning should be looked at together rather than in isolation.

Let's talk,

Kamila