Depreciation Recapture: What Investors Need to Know for Tax Season

What Is Depreciation Recapture?

Depreciation recapture is a tax provision that requires investors to repay a portion of the depreciation deductions they previously claimed when they sell a depreciable asset, such as rental real estate or business equipment, for a profit. While depreciation lowers taxable income during the holding period, the IRS “recaptures” the benefit at the time of sale, taxing the gain attributable to depreciation at a special rate.

How Depreciation Recapture Works

Assume you purchased a rental property for $300,000 and claimed $60,000 in depreciation over several years. Your adjusted cost basis is now $240,000. If you sell the property for $350,000, your total gain is $110,000. Up to the amount of prior depreciation ($60,000) is classified as depreciation recapture and is generally taxed at a maximum rate of 25%. The remaining $50,000 is treated as long-term capital gain, taxed at 0%, 15%, or 20% depending on your income bracket.

Depreciation Recapture Tax Rates

For real property, depreciation recapture is capped at 25%. For Section 1245 property, such as machinery or vehicles, the recaptured amount is taxed as ordinary income, which may be as high as 37% in 2023. Understanding these rates helps investors forecast their after-tax proceeds and avoid unpleasant surprises at closing.

Strategies to Minimize Depreciation Recapture

1031 Exchange: By rolling sale proceeds into a like-kind property, investors can defer both capital gains and depreciation recapture taxes.

Installment Sale: Spreading payments over multiple years can distribute the tax liability and keep you in a lower bracket.

Capital Improvements: Increasing basis through documented improvements reduces the portion subject to recapture.

Key Takeaways for Investors

Depreciation recapture can significantly impact your net profit, but careful planning and professional guidance can keep your tax bill manageable. Consult a qualified tax advisor before listing a property, model different sale scenarios, and consider strategic tools like 1031 exchanges to retain more of your hard-earned equity. Early awareness gives you leverage during negotiations and closing timelines.