Guides

Depreciation Recapture Explained

Depreciation recapture is generally one of the least understood pieces of the capital gains picture for San Diego, CA investment property owners. While an owner depreciates a building over its ownership period, generally twenty seven and one half years for residential rental property and thirty nine years for most commercial property, that annual depreciation deduction reduces taxable income year by year, but it also generally reduces the property's adjusted basis. When the property eventually sells, the amount of gain attributable to depreciation already claimed, known as unrecaptured Section 1250 gain, is generally taxed separately from the rest of the capital gain, at a federal rate of up to twenty five percent, which is generally higher than the zero, fifteen, or twenty percent long term capital gains rates that apply to the non-depreciation portion of the gain. This recapture generally applies whether or not depreciation was actually claimed on tax returns, since the Internal Revenue Service generally requires recapture on depreciation that was allowed or allowable, meaning an owner who failed to claim depreciation they were entitled to can still generally face recapture tax on it at sale. California generally does not offer a separate reduced rate for recapture income either, taxing it as ordinary income under the state's regular bracket schedule alongside the rest of the gain. A common misconception is that a 1031 exchange only defers the appreciation portion of a sale and that depreciation recapture must still be paid currently. In fact, a properly structured like-kind exchange generally defers both the capital gain and the depreciation recapture together, as long as the exchange fully reinvests the proceeds and the investor does not receive boot in the form of cash or debt relief that is not offset by new debt or additional cash into the replacement property. If an exchange is only partially completed, meaning some boot is received, the recapture portion is generally treated as recognized first, before any remaining capital gain, which can generally create a larger current tax bill than an investor expects from a partial exchange. San Diego, CA investors who have owned commercial or multifamily property for many years, and who have therefore accumulated substantial depreciation, generally have the most to lose from an outright sale and the most to gain from deferring that recapture through a properly structured exchange. We help investors and their tax advisors model the recapture exposure on a specific property before deciding whether to sell outright or pursue a like-kind exchange. Educational content only. This is not tax, legal, or investment advice, and investors should confirm their specific depreciation recapture exposure with a qualified tax advisor before selling.