Depreciation recapture is a separate tax from capital gains, and it catches a lot of owners off guard because the two get bundled together in casual conversation but are calculated and taxed differently. Every year a rental or commercial property is depreciated, the owner reduces their basis and gets a tax deduction against income; when the property sells, that accumulated depreciation is recaptured and taxed at a rate of up to 25%, separate from whatever the long-term capital gains rate would otherwise apply.
Why This Exists As Its Own Category
The IRS treats depreciation as a benefit the owner already received in the form of lower taxable income during the years of ownership. Recapture is the mechanism that claws back a portion of that benefit at sale, since the property didn't actually decline in value the way the depreciation schedule assumed. Section 1250 governs recapture on real property, and it's structured differently than the recapture rules for equipment or other personal property under Section 1245, which is one reason real estate depreciation recapture tends to be capped at 25% rather than taxed as ordinary income the way some equipment recapture is.
How Recapture Shows Up On A Nashville Commercial Sale
A commercial building in a submarket like Wedgewood-Houston or the Nashville industrial corridor near the airport, held for 15 years and depreciated on a 39-year straight-line schedule, will have accumulated a substantial depreciation deduction by the time it sells. That accumulated amount becomes the recapture base, taxed at up to 25%, while any remaining appreciation above the original purchase price is taxed at standard long-term capital gains rates. On an older building with slower recent appreciation but heavy depreciation, recapture can actually make up the larger share of the total tax bill, not the appreciation itself.
- Recapture applies to depreciation actually claimed, or that should have been claimed
- Section 1250 caps real property recapture at a 25% rate
- Recapture and capital gains are calculated and reported separately on the same return
- Cost segregation studies can increase depreciation deductions during ownership but also increase recapture exposure at sale
Deferring Recapture Through A 1031 Exchange
A properly structured 1031 exchange defers recapture tax along with the capital gains portion of a sale, since neither is triggered when proceeds roll into replacement property through a qualified intermediary rather than being distributed to the seller. The deferred recapture doesn't disappear; it carries forward and becomes due again if the replacement property is eventually sold without another exchange, or it can continue being deferred indefinitely through successive exchanges. This is one of the more overlooked reasons investors with heavily depreciated Nashville-area properties lean on exchanges rather than a straight sale.
A Case Where Recapture Gets Missed Entirely
Owners occasionally assume recapture only applies if depreciation was actually claimed on past returns, and skip reporting it on a property where deductions were never taken. The IRS calculates recapture based on allowed or allowable depreciation, meaning what the owner was entitled to claim under the applicable schedule, regardless of whether it was actually used. Skipping years of depreciation doesn't avoid recapture at sale; it just means the owner paid more tax during the ownership years without getting the corresponding deduction, while still owing recapture as if they had.
Common Questions
What is the maximum tax rate on depreciation recapture for real estate?
25%, under Section 1250, which is separate from and generally applied before the remaining gain is taxed at standard long-term capital gains rates.
Does a 1031 exchange defer depreciation recapture along with capital gains?
Yes. A properly structured exchange defers both the capital gains portion and the recapture portion of a sale by rolling the full gain into the replacement property's basis.
Is recapture owed even if the owner never claimed depreciation deductions?
Generally yes. The IRS bases recapture on allowed or allowable depreciation, meaning what the owner could have claimed, so skipping the deduction does not avoid the recapture liability at sale.
Does a cost segregation study increase recapture exposure at sale?
It can. Cost segregation accelerates depreciation deductions during ownership, which increases the accumulated depreciation subject to recapture when the property eventually sells.
Is recapture calculated differently for residential rental property than commercial property?
The mechanics are similar under Section 1250, though the depreciation schedules differ, 27.5 years for residential rental and 39 years for commercial, which changes how much depreciation accumulates over a given holding period.