Depreciation Recapture: The Tax Trap Waiting for Sellers

You sell a rental property or business equipment, expect a tidy capital gain, and your accountant hands you a bill with a big chunk taxed as ordinary income. That's depreciation recapture, the most common tax surprise for sellers of business and investment property. Below is how it works and why it matters before you sell.

Go deeper: a full walk through depreciation recapture and the tax on Big Sale Tax.

The deal you made years ago comes due

Every year you depreciated that property, you took a deduction against ordinary income. Recapture is the IRS collecting that benefit back when you sell, taxing the depreciated portion of your gain at ordinary (or special) rates instead of the lower capital-gain rate.

Two flavors: §1245 and §1250

• §1245 (equipment, machinery, personal property): ALL prior depreciation is recaptured as ordinary income, up to the full amount you deducted. This is the harsh one.
• §1250 (real property): only depreciation taken in excess of straight-line is recaptured as ordinary, usually $0 under modern MACRS. But the straight-line portion becomes "unrecaptured §1250 gain," taxed at a maximum 25%, higher than the 15 to 20% capital-gain rate.

Why it ambushes real estate sellers

A landlord who depreciated a building for 20 years can face a sizable slice of the gain taxed at 25% (unrecaptured §1250), plus regular capital-gain rates on appreciation, plus the 3.8% NIIT, plus California's ordinary rate. The "simple" sale has four different rates inside it.

What it comes down to

Depreciation isn't free money; it's a deferral you eventually settle up on. The sellers who keep the most understand recapture before they list, and structure the sale around it instead of discovering it on the tax return.