Depreciation Recapture

Detailed Explanation

When depreciable property is sold for more than its adjusted basis, depreciation previously claimed (or allowable, even if not claimed) is "recaptured" at higher tax rates than the standard long-term capital gain rate. The character and rate depends on the property type. Section 1245 recapture applies to depreciable personal property and components reclassified out of real estate via cost segregation (5-year, 7-year, 15-year property: equipment, fixtures, furniture, certain land improvements). Section 1245 recapture is taxed entirely as ORDINARY INCOME up to the amount of prior depreciation, with rates up to 37%. Section 1250 recapture applies to depreciable real property (the building itself, 27.5-year or 39-year MACRS). Section 1250 "unrecaptured gain" is the lesser of total accumulated depreciation OR total gain on sale, taxed at a maximum federal rate of 25% (vs 0/15/20% for regular long-term capital gains). On sale of a $500,000 residential rental held 10 years with $145,455 of accumulated depreciation, recapture exposure could reach $36,364 (25% × $145,455) just at federal level, plus state. The recapture trap erases much of the accelerated depreciation benefit if the property is simply sold. Strategies to defer or eliminate recapture: (1) Section 1031 like-kind exchange defers both gain and recapture into the replacement property, (2) holding until death triggers IRC §1014 basis step-up to fair market value, completely eliminating recapture for the heirs, (3) installment sales spread the recapture over multiple years, (4) Opportunity Zone investments can permanently exclude post-investment gain (different rules for original gain).