What is depreciation recapture, and why is it such a big number when I sell?
Every year you own a rental building, the tax code lets you deduct a slice of its cost — residential improvements depreciate over 27.5 years, straight-line. When you sell, the IRS takes those deductions back: the accumulated depreciation is taxed at up to 25% federally (plus California ordinary rates), separate from and on top of the capital-gains rate on the rest of your profit. On a building held twenty-plus years, recapture alone can run into the hundreds of thousands. A 1031 exchange defers it; dying with the building erases it; ignoring it just makes it a surprise.
How the number quietly gets huge.
Take a building bought for $2M with $1.4M allocated to improvements (land never depreciates). Straight-line over 27.5 years is about $51,000 a year in deductions — money that sheltered your rental income annually. Hold twenty years and you have taken roughly $1M in depreciation, which means your basis has dropped by $1M and every one of those dollars comes back as "unrecaptured Section 1250 gain" at sale, taxed at up to 25% federal plus up to 13.3% in California plus possibly the 3.8% NIIT. That is potentially $350,000–$400,000 of tax attributable to recapture alone — before the ordinary capital gain on the appreciation is even counted. The deduction was never free money; it was a loan from the IRS with the balloon due at closing.
The three ways out.
A 1031 exchange defers recapture right along with the capital gain — your old basis carries into the replacement property and the clock keeps running, which is why serial exchangers can defer for decades. Holding until death eliminates it: the step-up in basis resets everything, and the deferred recapture simply vanishes for your heirs — the "swap till you drop" strategy is built on exactly this. An installment sale can spread the recognition of straight-line recapture across the years you receive payments, smoothing brackets. What does not work is pretending it away: sellers who model their tax bill at 15–20% on the whole gain and skip the 25% layer on a third of it are the ones who call their CPA in April sounding wounded.
Do I owe recapture if I never actually claimed the depreciation?
Yes — the rule is depreciation "allowed or allowable," so the IRS reduces your basis whether you took the deduction or not. Not claiming it is the worst of both worlds; talk to a CPA about catching up before you sell.
Is the recapture rate always exactly 25%?
Up to 25% federally for straight-line depreciation on real property — it can be lower if your ordinary bracket is lower. California adds its ordinary rates on top, and higher earners add the 3.8% NIIT.
Does a 1031 exchange eliminate recapture or just delay it?
It defers it — the liability carries into the replacement property. It only disappears if you hold until death and your heirs receive the step-up in basis.
SHAYA LOWENSTEIN · LYON STAHL INVESTMENT REAL ESTATE · DRE #01942326 · (323) 944-2221