Depreciation Recapture: Meaning, Limitations, and Example

Depreciation recapture is a tax provision that applies when you sell a property that has been depreciated for tax purposes. When you take depreciation deductions over time usually on rental or business property you reduce your taxable income. However, when you sell the asset, the IRS may require you to "recapture" some or all of that depreciation and pay taxes on it, often at a different rate than standard capital gains.

In the U.S., depreciation recapture on real estate is generally taxed at a maximum rate of 25%, depending on your income and how much depreciation you’ve claimed. This provision ensures that the tax benefit you received through depreciation is accounted for when the property is sold.

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How Depreciation Recapture Works

Let’s say you buy a commercial property for £500,000 and over 10 years, you claim £150,000 in depreciation. Your adjusted basis in the property becomes £350,000. If you sell the property for £600,000, your total gain is £250,000 (£600,000 – £350,000). However, the first £150,000 of that gain—the amount equal to your prior depreciation—is taxed as recaptured depreciation, typically at 25%. The remaining £100,000 is taxed as a long-term capital gain, which may be taxed at a lower rate.

It’s important to note: even if you didn’t take depreciation deductions, the IRS may still treat it as if you did—this is called “allowed or allowable” depreciation. In other words, you can’t avoid depreciation recapture just by skipping the deductions.

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Limitations and Planning Considerations

One of the biggest challenges with depreciation recapture is the unexpected tax liability it creates. Many investors focus solely on capital gains tax and forget that the recaptured portion can significantly increase the total tax owed. If you're planning to sell an investment property, you’ll want to work with a tax advisor to estimate how much of your gain will be subject to recapture.

Fortunately, 1031 exchanges offer a legal way to defer both capital gains and depreciation recapture taxes. If you reinvest your sale proceeds into a like-kind property under IRS rules, you can postpone the tax hit indefinitely. However, the clock starts ticking if you ever cash out of the investment without using another 1031.

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Real-World Example

Imagine you purchased a rental property for £400,000 and claimed £80,000 in depreciation over several years. Your adjusted basis is now £320,000. You sell the property for £500,000, resulting in a total gain of £180,000. Of that gain, £80,000 will be taxed as depreciation recapture, while the remaining £100,000 will be treated as a capital gain.

This means that even though you benefited from depreciation during ownership, you’ll owe taxes on that portion when you sell—something many investors overlook until tax season.

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Final Thoughts

Depreciation recapture is one of the most overlooked aspects of real estate taxation, yet it can have a significant impact on your net proceeds from a sale. Whether you're planning to sell or reinvest, understanding how recapture works helps you avoid surprises and optimize your exit strategy. Work closely with a qualified tax advisor or CPA to calculate your exposure, and consider tools like 1031 exchanges or installment sales to manage the tax burden strategically. When used correctly, depreciation is a powerful tax tool but it comes with responsibilities on the back end.