Depreciation Recapture
Depreciation recapture is the IRS mechanism that taxes the gain from the sale of depreciable property at ordinary income tax rates to the extent that depreciation deductions were previously taken, preventing taxpayers from permanently converting ordinary income deductions into lower-taxed capital gains at the time of sale. For real estate, Section 1250 recapture on accumulated straight-line depreciation is taxed at a maximum rate of 25%.
When a taxpayer claims depreciation deductions on an asset — reducing taxable income year after year — those deductions reduce the asset's adjusted cost basis. When the asset is subsequently sold for more than the reduced adjusted basis, a portion of the gain represents the recovery of those previously deducted depreciation amounts. Congress designed the depreciation recapture rules to ensure that the tax benefit of the deductions (at ordinary income rates) is not converted into a lower-taxed capital gain upon sale.
For personal property (Section 1245 property), such as equipment, machinery, and vehicles, all depreciation taken is fully recaptured as ordinary income to the extent of gain. If the equipment was depreciated by $50,000 and is sold for a gain of $30,000, the entire $30,000 is ordinary income. If the gain is $60,000, the first $50,000 is ordinary income (recapture) and the remaining $10,000 is Section 1231 gain (potentially long-term capital gain).
For real property (Section 1250 property), such as buildings and improvements, the recapture rules are more favorable. Under current law, accelerated depreciation in excess of straight-line depreciation would be recaptured as ordinary income, but since the introduction of the Alternative Depreciation System and MACRS rules, most residential and commercial real property has been depreciated on a straight-line basis. As a result, actual Section 1250 recapture at ordinary rates is often minimal. However, the IRS taxes unrecaptured Section 1250 gain — the portion of gain attributable to straight-line depreciation previously deducted — at a maximum federal rate of 25%, rather than the standard 0%/15%/20% long-term capital gains rates.
For a real estate investor who has owned and depreciated a rental property for many years, the unrecaptured Section 1250 gain can be a significant component of the total taxable gain on sale. The investor must identify the total depreciation taken over the holding period, calculate the unrecaptured Section 1250 gain, and apply the 25% maximum rate to that portion before applying the standard long-term capital gains rates to any remaining gain.
In a 1031 like-kind exchange, depreciation recapture is deferred along with the capital gain — the cumulative depreciation carries over to reduce the basis of the replacement property. In an Opportunity Zone investment, the deferred gain (including any depreciation recapture component) is also deferred until December 31, 2026, or an earlier disposition.
Section 1250 recapture is reported on Form 4797 (Sales of Business Property) and flows to Schedule D and Form 1040. Brokerage 1099-B forms do not track depreciation recapture — this is the investor's responsibility to calculate and report.