When undergoing a 1031 exchange, investors often focus on deferring capital gains taxes associated with the sale of investment property. However, another important consideration is depreciation recapture—a provision that may require a portion of prior depreciation deductions to be taxed upon a triggering event, such as the sale or disposition of the asset.
If applicable, depreciation recapture can affect the total tax liability and reduce the net proceeds from a transaction. Understanding how this rule operates within the context of a like-kind exchange, and planning accordingly, may help investors maintain tax efficiency.
Depreciation in the Context of Real Estate Investments
In real estate investing, depreciation generally refers to the allocation of a property’s cost over its useful life for tax and accounting purposes. There are two main categories: accounting depreciation and market depreciation. The latter refers to the actual loss of Fair Market Value (FMV) due to market volatility, property damage, and other factors. Meanwhile, accounting depreciation refers to the paper loss that property owners assign to account for the wear and tear of the property over time, based on the asset’s expected useful life.
In this blog post, we’ll focus on accounting depreciation because the cumulative amount claimed under this method is what becomes subject to depreciation recapture upon the sale of a property.
Property owners have a few ways to depreciate their real estate assets. The straight-line method assigns a schedule for the asset’s depreciation: 27.5 years for residential property and 39 years for commercial property. Each year, the owner can depreciate the property by dividing the total value of the property by the number of years. The result can be taken as depreciation each year.
One benefit of applying depreciation — it helps reduce the income of investors. Accounting depreciation also provides a more realistic picture of the property’s value over time on financial statements.
What Is Depreciation Recapture 1031 Exchange?
When real property is sold in a taxable transaction, the total straight-line depreciation the taxpayer has deducted is taxed as ordinary income, but only up to the level of profit realized from the sale (with a maximum 25% tax rate). This process, known as depreciation recapture, allows the IRS to recover the tax benefits the owner received during the period of ownership. This recaptured gain is taxed at a maximum federal rate of 25%, subject to certain limits.
However, if the property is sold as part of a properly executed 1031 exchange, both capital gains and depreciation recapture can generally be deferred, provided that the taxpayer acquires a replacement property of equal or greater value, and that property includes depreciable improvements of comparable or greater value than those relinquished.
If the replacement property does not meet these criteria—for example, if a portion of the value is held in cash or non-depreciable property—then a portion of the gain may be recognized. This includes gains attributable to previously claimed depreciation deductions. This is sometimes referred to as partial recapture and may be taxed accordingly.
Finally, it’s important to note that even if depreciation recapture is deferred through a 1031 exchange, it is not eliminated. If the replacement property is eventually sold in a taxable transaction, any deferred depreciation will generally become recognizable at that time.
Example Calculation of Depreciation Recapture
Let’s create a scenario to better understand how depreciation recapture works in real life.
Asset: Apartment complex with original purchase price of $10,000,000
Accumulated Depreciation: $3,000,000
Cost-adjusted Basis: $7,000,000
Based on the property’s adjusted value, the next step is to calculate the gain on sale. Let’s say that you were able to sell the property at $11,000,000 thanks to favorable market conditions.
Final Sales Price – Cost-adjusted Basis = Gain on Sale
$11,000,000 – $7,000,000 = $4,000,000
In this case, the gain on sale is higher than the depreciated amount. The $3,000,000 is subject to depreciation recapture under IRC §1250. This portion may be taxed at a maximum federal rate of 25%. The remaining $1,000,000 is generally taxed at long-term capital gains rates, up to 20% federally (depending on income level).
Wrapping Up: Depreciation Recapture Like-Kind Exchange
While depreciation offers tax deferral opportunities by allowing property owners to deduct a portion of an asset’s value over time, it also introduces the potential for depreciation recapture when the property is sold. This happens when you sell a property for a profit after enjoying tax benefits from the annual depreciation. For 1031 exchanges, you’ll need to match the relinquished property’s equity and debt with a like-kind replacement of equal or greater value. This way, any potential depreciation recapture and capital-gains tax continues to be deferred rather than triggered at the time of the exchange.
Because depreciation recapture rules are complex and often dependent on property characteristics and transaction structure, it is advisable to work with qualified tax and real estate professionals to ensure the exchange complies with IRS regulations and preserves deferral opportunities.
Engaging experienced advisors may also help identify additional strategies that could improve tax efficiency, such as cost segregation studies, installment sale planning, or partial 1031 exchanges. Tailored guidance based on your financial and estate planning objectives can support more informed decision-making.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Article written by: Story Amplify. Story Amplify is a marketing agency that offers services such as copywriting across industries, including financial services, real estate investment services, and miscellaneous small businesses.
Sources:
https://www.investopedia.com/terms/d/depreciationrecapture.asp
