Depreciation Recapture Explained

Depreciation recapture is the tax owed on depreciation an investor was entitled to claim during ownership of a rental or investment property. Real property depreciates on a straight line basis, twenty seven and a half years for residential rental property and thirty nine years for commercial property, and each year of depreciation reduces the property's adjusted basis. When the property sells, the accumulated depreciation is recaptured, meaning it is taxed separately from the rest of the capital gain rather than simply folded into the standard long term capital gains rate.

For real property, this recapture is called unrecaptured Section 1250 gain, and it is taxed at a maximum federal rate of twenty five percent, higher than the top long term capital gains rate available to most investors. The remaining gain, the appreciation above the original basis that is not attributable to depreciation, is taxed at the standard long term capital gains rates of zero, fifteen, or twenty percent depending on income. Colorado, CO investors add the state's flat income tax rate on top of both pieces, since Colorado does not distinguish between recapture and ordinary capital gain.

A common misconception is that recapture only applies if the investor actually claimed depreciation on past tax returns. In fact, recapture is based on depreciation the investor was allowed to claim, whether or not it was actually claimed. An investor who never depreciated a rental property, whether through an oversight or a choice not to, still owes recapture tax as if the depreciation had been claimed. This makes reviewing past depreciation schedules, or filing a corrective study if depreciation was missed, an important step before a sale.

A 1031 exchange defers depreciation recapture along with the rest of the capital gain, as long as the exchange is properly structured and the investor reinvests the full net proceeds and equal or greater value into replacement property. The deferred depreciation carries forward into the replacement property's basis, where it remains subject to recapture on a future sale unless the investor exchanges again or the property eventually passes to heirs with a stepped up basis.

Denver, CO investors selling property that has been depreciated over many years, particularly commercial or multifamily assets with larger depreciable basis, should calculate the recapture exposure specifically and separately from the general capital gain, since it is often the single largest line item in the total tax bill on a sale.