Why Real Estate Investors Pay a Recapture Tax

jim kobzeff

Dec 10, 2015

Depreciation recapture is an Internal Revenue Service (IRS) procedure for collecting income tax from a real estate investor when he or she disposes of an asset that had been providing an offset to ordinary income through depreciation. The result is the recapture tax.

Here's the idea.

The Feds feel that any gain a real estate investor realizes when an investment gets sold is in part due to the depreciation allowance they've enjoyed during ownership (which in turn meant less revenue for the IRS). Now they expect the investor to pay for that accumulated depreciation allowance in order for them to "recover" that revenue by using depreciation recapture to tax the gain.

In other words, because the taxpayer received a deduction from ordinary income for the depreciation of the asset, any gain the taxpayer receives up to the depreciation amount must be included as ordinary income to offset the earlier deduction and taxed at the recapture tax rate. The net affect results in a higher tax liability for the investor than capital gain taxes alone.

Let's consider a simple example.

Say you own a commercial real estate building and have deducted $100,000 of depreciation over the years. That depreciation reduces your basis in the property and results in a bigger taxable gain (or smaller loss) when you sell. Now you sell for a $300,000 gain. The first $100,000 (the un-recaptured Section 1250 gain) is taxed at a maximum federal rate of 25% (and only the remaining $200,000 of gain is taxed at the "general rule" maximum federal rate of no more than 20%).

So rather than a tax liability of $60,000 (taxed at a capital gains rate of 20%), the investor will owe the Feds $65,000.

  • $100,000 accumulated depreciation times 25% equals $25,000
  • $200,000 remainder times 20% equals $40,000

General Guidelines

Recapture tax occurs when depreciable real estate is sold after one year of ownership at a gain. Property sold one year or less is classified as a "short-term" and gets taxed as ordinary income. Property sold at a loss can be deducted on your tax return and used to reduce other income.

Rule of Thumb

This article is intended only to give you a general idea of the depreciation recapture method. It is not tax advice. Real estate investing requires sound real estate investment tax strategies and good planning. It is recommended that you always consult a tax specialist before you sell any investment real estate property.

Here's to your real estate investing success.

So You Know

ProAPOD Executive 10 real estate investing software calculates the depreciation recapture tax to arrive at sales proceeds in the event of a sale.

james kobzeff author

James Kobzeff
Jim is a former realtor with over thirty years real estate investment property experience. He is the developer of ProAPOD's real estate analysis software solutions.