Depreciation recapture is the portion of gain on the sale of depreciable property that the IRS taxes at rates higher than long-term capital gains, recovering the tax benefit of prior depreciation deductions. It applies when a property sells for more than its depreciated adjusted basis, and it is not tax advice but a modeling reality every seller confronts at disposition.
How Depreciation Recapture Works
Depreciation recapture is governed by two sections of the Internal Revenue Code. Section 1250 covers depreciable real property, and Section 1245 covers depreciable personal property such as equipment and cost-segregated fixtures. For real estate depreciated on the straight-line method, the recovered amount becomes unrecaptured Section 1250 gain, taxed at a federal rate capped at 25%.
The mechanism starts with adjusted basis. Each year of ownership, an owner deducts depreciation, which lowers the property's tax basis. At sale, gain equals sale price minus that reduced basis, so the deductions taken during the hold reappear as taxable gain. The IRS then splits that gain into two buckets and taxes each differently.
Per the IRS and tax practitioners including EisnerAmper and Thomson Reuters, the split works as follows. Personal property under Section 1245 recaptures all depreciation taken as ordinary income, up to the amount of gain. Real property under Section 1250, when depreciated straight-line as nearly all commercial real estate is, generates unrecaptured Section 1250 gain taxed at a maximum 25% federal rate, above the 15% to 20% long-term capital gains rate but below top ordinary rates.
Code section | Property type | Recapture treatment |
|---|---|---|
Section 1245 | Personal property: equipment, fixtures, 5, 7, and 15-year cost-segregated assets | All depreciation taken recaptured as ordinary income, up to gain |
Section 1250 | Real property: buildings and structural components | Straight-line depreciation becomes unrecaptured 1250 gain, capped at 25% federal |
True Section 1250 recapture at ordinary rates applies only to depreciation taken in excess of straight-line, which is rare because commercial real estate uses straight-line by default. This is why most real estate recapture lands in the 25% unrecaptured bucket rather than the ordinary-income bucket.
Why Depreciation Recapture Matters
Depreciation recapture is the reason the after-tax proceeds from a sale often fall well below the headline capital gain. Every dollar of depreciation deducted during ownership lowers the property's adjusted basis, which raises taxable gain at disposition. An underwriter who models a sale on pretax proceeds alone overstates net cash to investors and the deal's true internal rate of return.
The tax is best understood as a timing settlement, not a penalty. Depreciation is a deferral: an owner shelters income during the hold, then repays part of that shelter at sale. A cost segregation study or bonus depreciation that front-loads deductions increases the recapture waiting at exit, so aggressive early depreciation and a near-term sale can surface the deferred tax before the time value of the acceleration is fully earned.
For an operator running a hold-sell analysis, recapture changes the math on refinancing versus selling. A cash-out refinance pulls equity without triggering recapture, while a sale settles it. That difference frequently tips long-horizon owners toward refinancing rather than disposition, especially on assets carrying large accumulated depreciation.
Example
This example is a step-by-step depreciation recapture calculation for a commercial property sold after a ten-year hold. The owner buys for $5,000,000, allocating $1,100,000 to land and $3,900,000 to the building. The building depreciates straight-line over the 39-year commercial schedule, and the property later sells for $6,500,000.
Line item | Amount |
|---|---|
Building basis (excluding land) | $3,900,000 |
Annual straight-line depreciation ($3,900,000 / 39) | $100,000 |
Accumulated depreciation over 10-year hold | $1,000,000 |
Original cost basis (land plus building) | $5,000,000 |
Adjusted basis at sale ($5,000,000 minus $1,000,000) | $4,000,000 |
Sale price | $6,500,000 |
Total gain ($6,500,000 minus $4,000,000) | $2,500,000 |
The $2,500,000 gain splits in two. The first $1,000,000, equal to accumulated depreciation, is unrecaptured Section 1250 gain taxed at the 25% maximum: $1,000,000 times 25% equals $250,000 of recapture tax. The remaining $1,500,000 is long-term capital gain, taxed at 20% for a top-bracket seller: $1,500,000 times 20% equals $300,000. Total federal tax is $550,000, of which $250,000 is recapture the owner would have missed by modeling the full gain at 20%.
Variations and Edge Cases
Depreciation recapture is not a single flat outcome. It varies with property type, depreciation method, and whether the seller reinvests through a like-kind exchange. The most consequential variation is the Section 1031 exchange, which defers both capital gains and recapture when sale proceeds roll into qualifying replacement property.
Situation | Effect on recapture |
|---|---|
Section 1031 exchange | Defers recapture and capital gains when replacing with like-kind depreciable real property of equal or greater value |
Cost segregation assets | 5, 7, and 15-year components become Section 1245 property, recaptured as ordinary income up to gain |
Sale at a loss | No recapture; recapture applies only to the extent of gain |
Excess over straight-line | Rare additional depreciation recaptured at ordinary rates under Section 1250 |
Installment sale | Section 1245 recapture is recognized in the year of sale, not spread across installments |
Per First American Exchange Company and Accruit, a 1031 exchange defers recapture only if the replacement property is itself depreciable, so exchanging into raw land does not shelter the recapture on an improved building. The deferred amount carries into the replacement property's basis and is recognized on a future taxable sale unless deferred again.
Depreciation Recapture vs Capital Gains
Depreciation recapture is often confused with capital gains tax. Depreciation recapture is the tax on gain attributable to prior depreciation deductions, taxed at up to 25% for real property under Section 1250 or ordinary rates under Section 1245. Capital gains tax is the tax on appreciation above original cost basis, taxed at 15% to 20% for long-term holds.
The two apply to the same sale but to different slices of gain. Recapture is measured first, up to accumulated depreciation, then any remaining gain above original cost is capital gain. A seller who ignores the split assumes the whole gain is taxed at the lower capital gains rate, understating the true tax bill on a depreciated asset by the recapture premium.
Frequently Asked Questions
What is the depreciation recapture tax rate on real estate? For commercial real estate depreciated on the straight-line method, recapture takes the form of unrecaptured Section 1250 gain, taxed at a maximum federal rate of 25%. That sits above the 15% to 20% long-term capital gains rate but below top ordinary income rates. State income tax may apply on top of the federal amount.
Can a 1031 exchange avoid depreciation recapture? A Section 1031 like-kind exchange defers depreciation recapture rather than eliminating it, provided the replacement property is depreciable real estate of equal or greater value. The deferred recapture carries into the new property's basis and is recognized when that property is sold in a taxable transaction, unless deferred again through another exchange.
What is the difference between Section 1245 and Section 1250 recapture? Section 1245 covers personal property such as equipment and cost-segregated fixtures and recaptures all depreciation taken as ordinary income, up to the gain. Section 1250 covers real property and, under straight-line depreciation, produces unrecaptured 1250 gain capped at 25%. Cost segregation shifts building dollars into Section 1245 assets, increasing ordinary-income recapture.