Depreciation Recapture

Depreciation recapture is the tax you owe when you sell a rental, charged on the depreciation you claimed against the building over the years you held it. It applies to residential rentals under Section 1250, is taxed at your ordinary rate up to a 25 percent ceiling, and, this is the part that surprises people, it applies to depreciation you were allowed to take even if you never actually took it.

The IRS lets you deduct a slice of the building each year you rent it. When you sell, it adds that running total back to your taxable gain and taxes it separately from the rest. The deductions felt free while you held the property. They were a loan, and the sale is the bill.

In practice

Say you buy a single-family rental for $300,000, with $60,000 of that allocated to land. The depreciable building basis is $240,000, recovered straight-line over 27.5 years, so roughly $8,727 a year. After 10 years you have claimed about $87,270 in depreciation. That lowered your cost basis from $300,000 to about $212,730.

Now you sell for $400,000 (ignore selling costs to keep the math clean). Your total gain is $400,000 − $212,730, or $187,270. Of that, $87,270 is unrecaptured Section 1250 gain, taxed at up to 25 percent: about $21,818 if you are at the ceiling. The remaining $100,000 is regular long-term capital gain, taxed at 0, 15, or 20 percent depending on your income. The recaptured piece does not get the lower capital-gain rate, which is why a sale can cost more than a quick gain estimate suggests.

Why it matters to a small landlord

Two things bite. First, you cannot skip depreciation to avoid the bill. The IRS recaptures what you were allowed to deduct, so a landlord who never claimed it pays recapture anyway and got no deduction in return. Run the numbers in the depreciation calculator and read how the 27.5-year math works so the annual deduction is on your return every year, not left on the table. Second, recapture is a reason the headline profit on a sale is not the cash you keep. Model it before you list.

Recapture sits next to a few terms worth knowing together. Your cost basis is what depreciation erodes year by year, and the recapture is the reckoning. The portion above recapture is capital gains, taxed at the lower long-term rate. And a properly structured 1031 exchange defers both the gain and the recapture into the next property, which is the main reason long-term holders use one instead of cashing out.