Understanding Depreciation Recapture on Rentals
If you own a rental property, you're probably familiar with depreciation, which allows you to claim an annual tax deduction for the wear and tear on your property.
But did you know that if you sell the property, the IRS can "recapture" that depreciation in one of two ways?
"First, the depreciation is subtracted from your cost basis, potentially generating larger capital gains on a sale," says Hayden Adams, CPA, CFP®, director of tax and wealth management at the Schwab Center for Financial Research. "Second, assuming your sale price is higher than your cost basis, the IRS taxes the depreciation portion as ordinary income, up to a maximum of 25%, depending on your income level."
In essence, depreciation recapture both increases the potential gain on your property and the rate at which a portion of the gain will be taxed.
Calculating taxes on depreciated property
Let's say you bought a condo for $500,000 and invested another $50,000 on interior renovations, for a total cost basis of $550,000. You rented it out for 10 years, claiming $20,000 in annual depreciation (your original cost basis divided by 27.5, the maximum number of years of depreciation permitted by the IRS). Subsequently, you sold the property for $800,000 in 2024.
Let's also say you're in the highest federal tax bracket, which in 2024 means your ordinary income is taxed at 37%, long-term capital gains are taxed at 20%, and you're subject to a net investment income tax of 3.8%.
Your tax bill would be determined by:
- Subtracting your total depreciation ($20,000 × 10 years) from your total cost basis ($500,000 + $50,000) to get your adjusted cost basis of $350,000.
- Subtracting your adjusted cost basis of $350,000 from your sale price of $800,000 for a profit of $450,000.
The first $200,000 in profit is subject to depreciation recapture and taxed at your ordinary income tax rate or 25%, whichever is less; the remaining $250,000 in profit is taxed at the long-term capital gains tax rate of 20%; and the entire gain is subject to a net investment income tax of 3.8%:
- Depreciation recapture: $200,000 × 25% = $50,000
- Long-term capital gains tax: $250,000 × 20% = $50,000
- Net investment income tax: $450,000 × 3.8% = $17,100
Total tax bill: $117,100*
*Excluding state taxes, where applicable.
If you're thinking, I'll just forgo the depreciation deduction, think again. "The IRS assumes you claimed depreciation whether you did or not," Hayden says.
That said, there are some ways to manage—and potentially even avoid—depreciation recapture:
- Execute a "like-kind exchange," which allows you to defer taxes on the gains by reinvesting them in another rental property. (For more, see Form 8824, "Like-Kind Exchanges.")
- Pass the rental property to your heirs, so that it gets a step-up in cost basis upon your death, which means your beneficiaries won't have reportable income on the depreciation.
- Donate the property directly to a charity or a donor-advised fund. You may be eligible for a tax deduction equal to the fair market value of the property and won't have to pay any taxes on the gain—assuming you've held it longer than a year, you've used straight-line depreciation,1 and your adjusted gross income (AGI) is high enough to realize the full charitable deduction, which is currently capped at 30% of AGI.
"The tax rules for rental properties are complex, so you should work with a tax professional to help you get all the deductions you may be entitled to and not run afoul of the guidelines," Hayden says.
1Straight-line depreciation = (cost of asset – estimated salvage value) ÷ estimated useful life of asset.