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When you sell a depreciated asset—like a rental property or business equipment—the IRS may require you to repay some of the tax benefits you previously claimed through depreciation deductions. This process, called depreciation recapture, can lead to a significant tax bill if not planned for. Here’s a breakdown of how it works, why it matters, and actionable strategies to minimize its impact.
What Is Depreciation Recapture?
Depreciation recapture is an IRS rule that taxes the profit from selling a depreciated asset as ordinary income, up to the amount of depreciation you previously claimed. The logic is simple: if you reduced your taxable income by depreciating an asset, the IRS wants to “recapture” those tax savings if you sell the asset for more than its adjusted cost basis.
Example:
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You buy a rental property for $300,000.
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Over 10 years, you claim $100,000 in depreciation deductions.
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The property’s adjusted cost basis becomes $200,000 ($300,000 – $100,000).
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You sell it for $350,000.
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The IRS taxes the $150,000 gain:
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$100,000 (depreciation claimed) is taxed as ordinary income (up to 25% for real estate).
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$50,000 (remaining gain) is taxed at capital gains rates (0%, 15%, or 20%).
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How Depreciation Recapture Works
Key IRS Rules
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Section 1250 Property: Applies to real estate (e.g., rental homes, commercial buildings). Recaptured depreciation is taxed at a maximum rate of 25%.
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Section 1245 Property: Applies to personal property (e.g., machinery, vehicles). Recaptured depreciation is taxed at your ordinary income tax rate.
Depreciation recapture ensures the IRS recoups tax benefits if the asset’s value doesn’t decline as expected.
How to Calculate Depreciation Recapture
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Determine the Adjusted Cost Basis:
Original Purchase Price + Improvements – Total Depreciation Claimed. -
Calculate the Gain:
Sale Price – Adjusted Cost Basis. -
Apply Recapture Rules:
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Gains up to the total depreciation claimed are taxed as ordinary income.
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Gains above that amount are taxed as capital gains.
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Formula:
Depreciation Recapture=Total Depreciation Claimed×Recapture Tax Rate
6 Strategies to Avoid or Minimize Depreciation Recapture
1. Use a 1031 Exchange
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How It Works: Reinvest proceeds from the sale into a “like-kind” property to defer taxes.
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Key Requirement: The replacement property must be of equal or greater value and include similar depreciable assets.
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Limitation: Recapture taxes are deferred, not eliminated.
2. Convert to a Primary Residence
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Section 121 Exclusion: Live in the property for 2 of the last 5 years before selling. Exclude up to $250,000 (single) or $500,000 (married) of gains.
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Catch: Only the portion of depreciation claimed during rental use is recaptured.
3. Allocate Value to Land
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Strategy: Assign a higher value to land (which isn’t depreciable) in purchase contracts.
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Example: If a $500,000 property is split as $300,000 (land) and $200,000 (building), only the building’s depreciation is subject to recapture.
4. Time the Sale Strategically
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Sell in a year with lower income to reduce your tax bracket.
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Monitor tax law changes that could affect rates.
5. Tax Loss Harvesting
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Offset depreciation recapture gains with losses from other investments.
6. Hold the Asset Until Death
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Step-Up in Basis: Heirs inherit the property at its current market value, eliminating depreciation recapture.
What Not to Do
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Avoiding Depreciation Deductions: The IRS still charges recapture taxes even if you didn’t claim depreciation.
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Ignoring Replacement Property Rules: A poorly executed 1031 exchange can trigger partial recapture.
Bottom Line
Depreciation recapture is an unavoidable reality for most property sellers, but strategic planning can reduce its bite. Tools like 1031 exchanges, primary residence conversions, and value allocation can defer or minimize taxes. Always consult a tax professional to tailor these strategies to your situation and stay compliant with IRS rules.
