How to Calculate Depreciation Recapture on a Rental Property
- Rick Ruberg
- Oct 22
- 6 min read
Updated: Oct 30
You've just sold an investment property for a healthy profit. Congratulations!
But then your accountant hits you with the news...
You owe depreciation recapture taxes on all those deductions you’ve been claiming on the property. What felt like a victory suddenly comes with a hefty tax bill.
Depreciation is more like a loan from the IRS than a gift.
Sooner or later, you’ll have to pay Uncle Sam.
This article will show you how depreciation recapture works, what it costs you when you sell, and most importantly, how to use strategic property purchases to offset those taxes and come out ahead.
Part 1: Understanding Depreciation Recapture
How Depreciation Works
When you own investment real estate, the IRS allows you to depreciate the property over its useful life (27.5 years for residential rental properties and 39 years for commercial properties). This depreciation is a non-cash expense that reduces your taxable income each year, effectively lowering your current tax liability.
Example:
You purchase a residential rental property for $550,000.
After allocating $50,000 to land (which cannot be depreciated), your depreciable basis is $500,000.
Each year, you can deduct approximately $18,182 in depreciation ($500,000 ÷ 27.5 years).
If you're in the 37% tax bracket, that annual deduction saves you roughly $6,727 in taxes every year you own the property.
The Trade-Off: How Depreciation Reduces Your Basis
Every dollar of depreciation you claim reduces your property's cost basis. Your basis is what you originally paid for the property, adjusted for improvements and depreciation.
Continuing our example:
After five years of ownership, you've claimed $90,910 in depreciation deductions. Your adjusted basis has dropped from $500,000 to $409,090.
The Moment of Truth: Calculating Your Capital Gain
When you sell the property, your taxable gain is calculated using this reduced basis:
Capital Gain = Sale Price − Adjusted Basis
Let's say you sell the property for $650,000:
Sale Price: $650,000
Adjusted Basis: $409,090
Total Gain: $240,910
>> here's where it can get expensive.
The Depreciation Recapture Tax Bill
The IRS divides your gain into two parts, each taxed differently:
1. Depreciation Recapture (taxed at up to 25%)
The $90,910 you claimed in depreciation is recaptured and taxed at ordinary income rates, up to a maximum of 25%.
$90,910 × 25% = $22,728 in recapture tax
2. Capital Gains (taxed at 15% or 20%)
The remaining gain of $150,000 ($240,910 total gain − $90,910 recapture) is taxed at the preferential long-term capital gains rate.
$150,000 × 15% = $22,500 in capital gains tax
Total Tax Bill: $45,228
That's a substantial check to write to the IRS. But remember, you saved approximately $33,635 in taxes over those five years ($6,727 × 5 years). So you're still ahead by about $11,600 after accounting for the time value of money.
Depreciation deferred your taxes... it didn't eliminate them.
Part 2: Using New Property to Offset Taxes
Now that you understand the cost of depreciation recapture, let's talk about the solution: using depreciation from a new property purchase to offset your capital gains tax liability.
How New Property Depreciation Offsets Capital Gains
When you purchase a new investment property, you immediately start generating depreciation deductions again. These deductions reduce your taxable income dollar-for-dollar, which means they can effectively offset the tax liability from your property sale.
Here's how the math works:
You just sold a property and face a $45,228 tax bill from our example above.
Within the same tax year, you purchase a new investment property for $1,000,000 with a depreciable basis of $900,000 (-$100,000 to land).
Annual Depreciation on New Property:
$900,000 ÷ 27.5 years = $32,727 per year
If you're in the 37% tax bracket, this depreciation saves you:
$32,727 × 37% = $12,109 in tax savings
The Multi-Year Offset Strategy
While the new property's depreciation doesn't completely eliminate your tax bill in year one, it significantly reduces it. And the depreciation continues for decades.
Year 1: Tax savings of $12,109 offset against your $45,228 tax bill
Year 2: Another $12,109 in tax savings
Year 3: Another $12,109 in tax savings
Year 4: Another $12,109 in tax savings
(you've now saved $48,436 total, more than your original tax bill)
Over four years, the depreciation from your new property has more than offset the entire tax liability from your sale. And you still have 23.5 more years of depreciation deductions ahead of you.
Why This Strategy Works
This approach leverages the fundamental tax principle that depreciation offsets ordinary income. Since recapture is taxed at ordinary income rates (up to 25%), and capital gains at 15-20%, every dollar of depreciation you generate provides tax relief.
Make sure your timing and planning is strategic:
Plan property purchases around anticipated sales
Ensure they have sufficient tax liability to benefit from the deductions
Consider holding period (the longer you hold, the more depreciation you accumulate)
The 1031 Exchange Alternative
If you want to defer 100% of your capital gains taxes immediately, consider a 1031 like-kind exchange. This allows you to sell one investment property and purchase another of equal or greater value while deferring all capital gains and recapture taxes.
Part 3: Supercharging with Cost Segregation
Standard depreciation is powerful, but what if you could accelerate those deductions dramatically?
Whelp, that's exactly what cost segregation does.
What Is Cost Segregation?
Cost segregation is an IRS-approved tax strategy that involves conducting an engineering-based study of your property to identify components that can be depreciated over shorter time periods than the building itself.
Instead of depreciating your entire property over 27.5 or 39 years, cost segregation identifies specific components that qualify for 5, 7, or 15-year depreciation schedules:
5-Year Property:
Carpeting & flooring
Appliances & fixtures
Decorative lighting
Window treatments
7-Year Property:
Office furniture & equipment
Built-in cabinets & millwork
Specialty electrical work
15-Year Property:
Landscaping & site improvements
Parking lots & driveways
Fencing & retaining walls
Sidewalks & curbing
The Dramatic Impact: Standard vs. Cost Segregation
Let's revisit our $1,000,000 property purchase with a $900,000 depreciable basis.
Standard Depreciation Approach:
$900,000 ÷ 27.5 years = $32,727 annual deduction
Tax savings in year one (at 37% rate): $12,109
With Cost Segregation Study: After the engineering analysis, assume the study identifies:
$180,000 in 5-year property (20% of basis)
$90,000 in 7-year property (10% of basis)
$90,000 in 15-year property (10% of basis)
$540,000 remaining in 27.5-year property (60% of basis)
First-Year Depreciation:
5-year property: $180,000 ÷ 5 = $36,000
7-year property: $90,000 ÷ 7 = $12,857
15-year property: $90,000 ÷ 15 = $6,000
27.5-year property: $540,000 ÷ 27.5 = $19,636
Total First-Year Deduction: $74,493 Tax savings (at 37% rate): $27,562
That's more than double the standard depreciation benefit—an additional $15,453 in tax savings in year one alone.
With bonus depreciation back at 100%, the first-year benefits can be even more dramatic, allowing you to deduct 100% of the 5-year and 7-year property immediately.
Who Should Consider Cost Segregation?
Cost segregation makes financial sense when the tax savings significantly exceed the cost of the study.
Based on industry standards, consider cost segregation if...
Property Characteristics:
Properties with a depreciable basis of $500,000+ are typically good candidates
Properties exceeding $1,000,000 in depreciable basis are excellent candidates
Recent purchases, new construction, or major renovations (within the last 10 years)
Renovations costing $200,000 or more
Property Types:
Multifamily properties (apartments, condos)
Single-family rental homes
Commercial buildings (retail, office, industrial)
Self-storage facilities
Hotels and hospitality properties
Investor Profile:
You have sufficient tax liability to benefit from accelerated deductions
You're in a high tax bracket (preferably 32% or higher)
You plan to hold the property for several years
You're actively generating rental income or have significant income to offset
A Cost Segregation study typically costs $4,000 - $10,000 depending on property complexity, but the tax savings often exceed the cost by 10x in the first year alone.
Use Timing To Your Advantage
Cost segregation is most powerful when...
You've just sold a property and need to offset capital gains immediately
You have a high-income year and want to reduce ordinary income taxes
You're in the year of acquisition or shortly after (to maximize the years of accelerated depreciation)
You're planning a major renovation and can do both a pre-renovation and post-renovation study
The Bottom Line
Depreciation recapture might sound intimidating, but it’s really just a matter of planning ahead.
With the right strategy, they can use new property acquisitions to balance out recapture taxes and actually come out on top.
Cost segregation takes this approach even further, speeding up deductions to deliver immediate and significant tax savings. By grasping how depreciation, recapture, and smart property buying work together, you can turn what looks like a tax burden into an incredible opportunity for building wealth.
Ultimately, it’s all about being informed and ready. Now that you’ve got a handle on these strategies, what’s your next move?
Next Steps:
Consult with a qualified tax advisor to assess your specific situation
If you meet the criteria, request a cost segregation feasibility analysis
Plan your property acquisitions and sales strategically around tax implications
Keep detailed records of all improvements and expenses for future cost seg studies
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Stay informed. Stay strategic. Stay hopeful.
This article is for educational purposes only and does not constitute tax, legal, or financial advice. Consult with qualified professionals before implementing any tax strategies.
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