Depreciation recapture, explained simply.

Why the deduction exists in the first place

The tax code assumes buildings wear out. Every year you own a rental, you can deduct a portion of the building's cost against your rental income, as though the building were slowly being used up. Land does not wear out, so land value is excluded.

Residential rental property is depreciated over 27.5 years. Commercial property is depreciated over 39 years. If you bought a rental house for $200,000 and $160,000 of that was building rather than land, you deduct roughly $5,818 every year.

That deduction is genuinely valuable. Over twenty years it shelters roughly $116,000 of rental income from tax. For most small landlords, depreciation is the reason a property that generates positive cash flow shows a loss on the tax return.

What happens when you sell

Here is the part nobody explains. Depreciation does not just reduce your income. It also reduces your basis, which is the number the IRS uses to measure your gain.

Notice what happened. You paid $200,000 and sold for $800,000, so it feels like a $600,000 gain. The taxable gain is $720,000, because depreciation shrank your basis by $160,000.

Then that $720,000 gets split into two buckets, taxed at different rates:

• $160,000 equal to the depreciation taken, taxed as unrecaptured Section 1250 gain at up to 25 percent. That is $40,000.
• $560,000 of genuine appreciation, taxed at long-term capital gains rates of 0, 15, or 20 percent. At 20 percent that is $112,000.

On top of both, the 3.8 percent net investment income tax on the full $720,000 adds $27,360, and a state like California taxing the whole gain at 12.3 percent adds $88,560. The total comes to roughly $267,920 on an $800,000 sale.

How to estimate your own recapture

The exact figure is on your depreciation schedule, which your CPA produces every year as part of Form 4562. If you do not have it, here is a workable estimate:

1. Take your original purchase price plus any capital improvements.
2. Multiply by roughly 0.80 to isolate the building from the land. The right ratio comes from your county assessor's split, and in high-land-value areas like coastal California it may be closer to 0.60.
3. Divide by 27.5 for residential property to get the annual deduction.
4. Multiply by the number of years you have rented it, capped at 27.5 years.
5. Multiply that total by 0.25 for the federal recapture tax.

The tax calculator on this site does all of that automatically, and lets you type over the estimate if you know the real number.

Why this hits long-time owners hardest

Depreciation runs out after 27.5 years. Once you cross that line, your basis in the building is essentially zero and cannot go lower. From then on, every dollar of sale price above the land value is gain.

That is why the tax bill on a property held thirty-five years is so much worse than the arithmetic suggests. The firefighter in our case study paid $35,000 for a house in 1990 and was offered $675,000. His basis was close to nothing, so nearly the entire $622,000 was gain, and $181,200 of tax was waiting behind an offer that looked like a clean, simple deal.

How a 1031 exchange handles it

A properly completed 1031 exchange defers depreciation recapture in full, alongside the capital gain. The deferred recapture carries forward into the replacement property and rides along with it.

There is a second benefit that gets overlooked. The exchange establishes a new basis and a fresh depreciation schedule on the replacement property. If you exchange into a DST, that new depreciation is what shelters most of the income you receive going forward. This is why DST distributions are often 60 to 90 percent tax-free in the early years while the rent from your old, fully depreciated rental was taxable to the last dollar.

And if you hold the replacement property until death, your heirs receive it at fair market value under current law. The deferred recapture, along with the deferred gain, disappears. Nobody ever pays it.