Depreciation Recapture Explained

Depreciation recapture is one of the most misunderstood costs in a real estate sale, because it is calculated separately from ordinary capital gain and taxed at a different rate. Every year an investor owns rental or commercial property, the IRS allows a depreciation deduction that reduces taxable income, based on the theory that the building's structure gradually wears out over its useful life. Land is not depreciable, only the building and certain qualifying improvements. When the property is later sold, the accumulated depreciation must be recaptured, meaning the portion of gain attributable to that depreciation is taxed as unrecaptured Section 1250 gain, generally at a maximum federal rate of twenty-five percent, rather than at the lower long term capital gains rate that applies to appreciation.

Why Recapture Surprises San Francisco, CA Investors

Investors who have owned property for a long time, or who used a cost segregation study to accelerate depreciation on shorter lived components such as flooring, fixtures, or site improvements, often have larger recapture exposure than they expect, because faster depreciation in early years means more of the eventual gain is characterized as recapture rather than general appreciation. A San Francisco, CA investor selling a multifamily building held for fifteen or twenty years may find that a substantial share of the total gain is recapture, taxed at the higher twenty-five percent federal rate, in addition to standard capital gains tax on the remaining appreciation. California then taxes the entire recognized gain, including the recapture portion, as ordinary income at the state level, since California does not distinguish recapture from other capital gain for state tax purposes.

Deferring Recapture With a 1031 Exchange

A properly structured Section 1031 exchange defers depreciation recapture along with the standard capital gain, as long as the investor reinvests in like kind replacement property held for investment or business use and follows the identification and closing deadlines. The deferred recapture generally carries over into the replacement property's basis, meaning it is not eliminated, only postponed until the replacement property is eventually sold in a taxable transaction, or deferred again through a subsequent exchange. This carryover effect is important for San Francisco, CA investors to understand, since an exchange does not erase the eventual recapture liability, it simply moves the taxable event into the future, potentially indefinitely if the investor continues exchanging or if the property is eventually inherited by an heir who receives a stepped up basis.

Because the recapture calculation depends on the specific depreciation method used, whether straight line or an accelerated cost segregation approach, and the exact accumulated depreciation taken over the holding period, we recommend San Francisco, CA investors obtain a depreciation schedule from their CPA or prior tax returns before listing a property for sale. This lets the investor and their advisor calculate the actual recapture exposure in advance, rather than discovering it for the first time on the tax return filed after closing, and it lets us help evaluate whether a 1031 exchange, a partial exchange, or an outright sale best balances the investor's liquidity needs against the recapture and capital gains tax that a taxable sale would trigger.