One of the many advantages of real estate investment is the use of depreciation, which allows investors to lower their tax burdens for any given year. Because all buildings experience wear and tear, the IRS permits taxpayers to write off the value of an asset and receive tax savings through depreciation deductions. While this is a great benefit, the IRS taxes that depreciation upon the sale of a property through a depreciation recapture tax.
Investors can take depreciation on property improvements only. That means they can depreciate anything built on the land, but not the land itself. Some investors may use accelerated depreciation, which allows them to take more depreciation in the initial years of the investment.
Depreciation Recapture and Useful Life
Nothing comes free, however, and the IRS limits the use of depreciation. As an example, an asset can be depreciated only over certain periods of time based on its useful life. For residential buildings, that useful life is considered 27.5 years. For commercial property, it’s 39 years. To calculate the annual amount of depreciation using the straight-line method, divide the cost basis of the building by its useful life.
If using accelerated depreciation, these useful-life calculations can be altered by claiming more depreciation at the front end. This can offset taxes due in the years accelerated depreciation is claimed. However, the investor would not have depreciation left in the later years. Nonetheless, it is a strategic maneuver to reduce the tax burden in years when it may be needed most.
When Depreciation Recapture is Triggered
Depreciation recapture is triggered upon the sale of an asset. This event requires taxpayers to consider the gain on the investment and the amount of taxes they offset during their ownership. Since ordinary income is reduced over the hold period, depreciation recapture allows the IRS to claw back the realized gain a taxpayer earns from the asset sale.
When an investor sells an asset, they calculate gain or loss to determine the total taxes due upon sale. If they used depreciation during the hold period, then the cost basis is lowered by the amount used. The lower cost basis means the gain will be higher and subject to taxes. The gain up to the amount of depreciation taken is the depreciation recapture tax due upon sale.
Depreciated assets can vary from rental properties to equipment. They are categorized as either personal property, under Section 1245, or real property, under Section 1250, or depreciable business property under Section 1231 of the Internal Revenue Code (see below). Investment properties that sell for a gain typically incur a capital gains tax. But other assets, such as equipment, do not. This is because the value of equipment decreases over time, whereas real estate typically increases in value. And it means that any gain from a property sale usually will incur both capital gains and depreciation recapture taxes.
Depreciation recapture on property is taxed at a rate of 25%. To calculate this, first take annual depreciation—cost basis divided by the property’s useful life—and multiply it by the hold period. That figure is the accumulated depreciation. Then, multiply that number by 25%. Keep in mind that the actual amount paid depends on the method used to calculate it (more about that when we discuss Section 1250 gains).
Depreciation Recapture in a 1031 Exchange
Avoiding or deferring taxes such as capital gains and depreciation recapture should be a part of every serious investor’s strategy. Using a 1031 exchange when selling property can help investors keep more money in their pockets by deferring both capital gains and depreciation recapture taxes. The wealthiest often look to these types of tax strategies to keep as much of their gains as possible.
To understand how to utilize a 1031 exchange, investors need to understand the intricacies of tax law. This can get confusing, and misunderstandings can lead to penalties and tax payments. The Tax Code categorizes personal property as Section 1245—anything that is not a building, such as a truck used for business. Real property, categorized as Section 1250, includes buildings, land and investment properties. Understanding Section 1250 can meaningfully change depreciation calculations. And that will help determine the viability of a property investment strategy.
For Section 1250 property, there is a further subdivision: Section 1250 recapture and unrecaptured Section 1250.
Section 1250 recapture: Depreciation claimed in excess of the straight-line calculation method, or the difference between accelerated depreciation and straight-line. This is taxed at ordinary income tax rates. Most property is depreciated under the straight-line method. However, if accelerated or bonus depreciation is used, Section 1250 recapture applies.
Unrecaptured Section 1250: The gain up to the total accumulated depreciation, excluding the Section 1250 recapture. This is taxed at the depreciation recapture tax rate, which is a maximum of 25% based on current legislation. In other words, the previously used depreciation is turned back into income.
1031 Exchanges and Cost Basis
In a 1031 exchange, the cost basis is the price paid plus any capital expenditures, less the accumulated depreciation. This basis will roll over into the replacement property following the exchange. It’s a common misunderstanding that the cost basis in the relinquished property is what the investor paid for it, but that’s not true. (Are you considering employing a 1031 exchange? Use our 1031 Exchange Calculator to determine how much you could save versus a traditional sale.)
Below is the depreciation recapture and the adjusted cost basis on an asset bought in 2020 and sold in 2024. The sale results in a total realized gain of $544,182. Of that total, $470,000 is subject to capital gains taxes and $74,182 is subject to depreciation recapture tax.
Calculating Depreciation Recapture on a Property
This chart demonstrates how to calculate depreciation recapture and capital gains tax due. But it also clearly shows the power of utilizing a 1031 exchange. In this example, the investor keeps $156,375 in their pockets, building meaningful wealth instead of losing it forever.
There are many benefits to depreciation including its ability to offset your taxable income; however, it’s important to be aware of depreciation recapture, which causes you to pay taxes on the depreciation taken over the life of your investment. When more money stays in your pocket, the effects can be powerful for preserving your wealth.
