When it comes to real estate investment, tax deferral strategies like the 1031 exchange often take center stage. But there’s another concept investors need to understand to truly see the big picture: recapture of depreciation.
It sounds technical but the reality is simple: the IRS lets you take deductions during ownership, but they expect their share when you sell. Understanding how depreciation and recapture work can make the difference between a well-planned strategy and an unwelcome tax surprise.
What Is Depreciation?
Depreciation allows property owners to deduct the theoretical wear and tear of their investment property over time (IRS Code §167). These deductions reduce taxable income during ownership and provide meaningful cash flow benefits.
For example, residential rental property is depreciated over 27.5 years, and commercial property is depreciated over 39 years (IRS Code §168). Every year, investors may write off a portion of their property improvement’s value. This is a tax benefit that adds up quickly.
The Catch: Recaptured Depreciation
When you sell the property, the IRS doesn’t forget about those past deductions. They “recapture” the depreciation by taxing the portion of your gain that is tied to the depreciation you previously claimed.
For most real estate, the rate for recaptured depreciation is generally taxed at a maximum of 25% (IRS Code §1250). If you took advantage of accelerated depreciation (such as, from a cost segregation study under IRS Code §1245), you may be subject to even higher rates of taxation.
Sometimes there are structural components that are designated as property with a shorter depreciation schedule. If property with an accelerated depreciation recapture attribute is sold in a 1031 Exchange, the depreciation recapture must be recognized to the extent that the new replacement property doesn’t have enough components eligible for rapid depreciation (e.g., insufficient IRS Code §1245 property.)
Tax rates are higher for recapture of depreciation. This means that even if you benefited from lower ordinary income tax rates while owning the property, you may owe at a higher rate when you sell.
Without planning, investors can be surprised by how much of their profit goes to the IRS through recapture.
Where 1031 Exchanges Come In
A 1031 exchange is a tax deferral tool. This type of exchange (IRC §1031) can defer capital gains taxes and the recapture of depreciation. When you roll proceeds into another like-kind property or properties, both types of tax liability may be pushed into the future.
That deferral can be a powerful wealth-building tool. But it is important to remember that liability does not disappear - it is deferred. When you eventually sell without exchanging, the IRS will expect both capital gains and depreciation recapture.
Why This Matters for Investors
Understanding recaptured depreciation is not about getting lost in the weeds of the tax code. It is about being prepared:
Plan for the Exit: Whether you exchange or sell outright, know what tax consequences to expect.
Run the Numbers: Work with your CPA or tax advisor to model the impact of depreciation recapture in your strategy.
Use Exchanges Wisely: A 1031 exchange can give you more time and flexibility, but it is not a permanent escape hatch.
The Bigger Picture
Real estate investment is about more than buying low and selling high. The tax rules that apply along the way can dramatically shape your returns. Recaptured depreciation is one of those rules every investor needs to respect.
Handled wisely, it is simply part of the cycle of investing. Handled poorly, it can erode your hard-earned equity.
The key is clarity: know how depreciation works, plan for its recapture, and use tools like the 1031 exchange (IRC §1031) to align your tax outcomes with your long-term investment goals.
If you are considering a 1031 exchange, feel free to call me, Jeff Peterson, at 612-643-1031, or email me at jeffp@CPEC1031.com.
Defer the tax. Maximize your gain.
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