Depreciation lets you deduct the cost of property over time. Recapture is the IRS getting some of that back when you sell. The depreciation you took comes off your basis, so your gain is bigger; on top of that, part of the gain is taxed at ordinary income rates instead of the lower capital-gain rates.
The math, in two scenarios
Sell a piece of equipment. You bought a $50,000 machine, depreciated $30,000 of it (bonus depreciation took a chunk in year one), and sell it for $45,000 four years later. Adjusted basis is $20,000 ($50,000 minus $30,000). Gain is $25,000. Under § 1245, the first $30,000 of gain would be ordinary recapture, but your gain is only $25,000, so the whole $25,000 is taxed as ordinary income, not capital gain.
Sell a rental. You bought a property for $400,000 (land + building). You allocated $80,000 to land, $320,000 to building. After ten years of depreciation, you have written off about $116,000 of building basis. You sell for $700,000. Gain is roughly $416,000. The first $116,000 is “unrecaptured § 1250” taxed at 25%. The rest is long-term capital gain at 20%. Plus 3.8% NIIT on top, if you’re a high earner.
Cost seg + recapture: the trade-off
If you did a cost segregation study on the rental and pulled $80,000 of basis into 5- and 7-year buckets, those pieces are personal property at the sale. Now they fall under § 1245 (full ordinary recapture) instead of § 1250 (25% rate). The accelerated depreciation up front is real money; the harsher recapture at the back end is real money too. Whether the trade pays out depends on hold period and tax-rate assumptions across the years.
Ways to manage it
- 1031 exchange. A like-kind exchange of real estate defers recapture (and the rest of the gain) into the replacement property. The deferred recapture stays with you and comes due when you sell the replacement, unless you 1031 again. See the 1031 article.
- Installment sale. Spreading the gain over years can soften the hit. Depreciation recapture, though, is reported all in the year of sale, not spread; see the installment sales article.
- Hold until death. Stepped-up basis at death wipes out the depreciation recapture entirely. Inheritors take a fresh basis equal to fair market value, and the prior depreciation history disappears.
- Net against passive losses. If you have suspended passive losses, they free up when the activity is disposed of (in a fully-taxable sale) and net against the gain.
The point
Recapture is not optional or surprising. It is the price for the depreciation deductions. The right time to think about it is before you buy, before you cost seg, and before you sell, not on the closing statement.