Tax Strategies
Depreciation Recapture Tax
How depreciation recapture tax is calculated when an Illinois investor sells real estate, why it is often bigger than expected, and how to defer it.
Depreciation lowers an Illinois investor's taxable income every year they own a property, and it does not come free. The IRS recaptures a portion of that benefit when the property sells, taxing the depreciation an owner claimed at a rate separate from ordinary capital gains. Investors who never connected these two facts, the annual deduction and the eventual recapture bill, are usually the ones most surprised by the number their CPA comes back with at closing. The longer a property is held and depreciated, the larger that number tends to grow, which means recapture exposure often peaks right around the time an owner is most tempted to finally sell.
01
How the Recapture Calculation Actually Works
For real property, the recaptured depreciation, known as unrecaptured Section 1250 gain, is taxed at a maximum federal rate of 25 percent, separate from the long-term capital gains rate applied to the rest of the gain. An investor who claimed $150,000 in depreciation on a Peoria commercial building over a fifteen-year hold owes tax on that $150,000 at the recapture rate, on top of whatever capital gains rate applies to the appreciation above the original purchase price.
Commercial property depreciates over 39 years under current rules, while residential rental property depreciates over 27.5 years, so a residential owner accumulates recapture exposure faster per year of ownership than a commercial owner holding a similarly priced building. Land itself is never depreciated, so only the portion of the purchase price allocated to the building generates recapture, which is why an accurate land-versus-building split at purchase matters years later at sale.
02
Why the Deduction Feels Free Until It Is Not
Depreciation reduces taxable rental income every year without requiring the owner to spend any actual cash, which is part of why it is such a valuable deduction while a property is held. The tradeoff shows up only at sale, when that accumulated benefit converts into a tax liability regardless of whether the property actually declined in value the way the depreciation schedule assumed. A Springfield landlord who depreciated a building for two decades owes recapture on the full amount claimed, even if the building's real market value rose the entire time. Some owners respond by simply not claiming depreciation to avoid the eventual recapture, but that strategy backfires, since the IRS calculates recapture on allowable depreciation whether or not it was actually taken on the return.
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Deferring Recapture Through a 1031 Exchange
Recapture is deferred, not eliminated, when a property moves through a properly structured 1031 exchange, since the exchange defers the full gain, including the recapture component, and carries it forward into the replacement property's basis. An investor exchanging out of a heavily depreciated Chicago-area apartment building into a new industrial property or a DST interest avoids paying the recapture bill at that closing, though the deferred amount stays attached to the replacement property and can resurface at a future sale without another exchange. Some investors choose to keep exchanging indefinitely for this reason, passing the deferred recapture forward from property to property rather than ever triggering it during their lifetime.
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Why Cost Segregation Makes This More Complicated
Investors who used cost segregation studies to accelerate depreciation on certain building components may have a more complex recapture calculation, since some accelerated components are taxed under different recapture rules than standard straight-line depreciation on the building itself. An owner who aggressively front-loaded depreciation through cost segregation should get a precise recapture estimate before listing a property, since the number can differ meaningfully from what a simple straight-line assumption would suggest. This is one of the more common reasons a rough online estimate of recapture ends up far off from what actually appears on the closing statement.
Questions
Common questions
Is depreciation recapture taxed the same as ordinary income?
No, unrecaptured Section 1250 gain on real property is capped at a maximum federal rate of 25 percent, which is different from both ordinary income rates and standard long-term capital gains rates.
Does recapture apply if I never actually claimed depreciation on my rental?
Yes, the IRS calculates recapture based on depreciation the owner was allowed to claim, whether or not it was actually taken, so skipping the deduction does not avoid the recapture tax and usually means amended returns are worth filing.
Can a 1031 exchange defer recapture on a property with a cost segregation study?
Generally yes, though the mechanics can be more complex, and an investor with an accelerated depreciation history should work with a CPA experienced in cost segregation before structuring the exchange.
How is recapture calculated on a property held through multiple owners over the years?
Each owner's recapture exposure is generally tied to the depreciation they personally claimed during their ownership period, so a property with a long chain of prior owners does not carry forward recapture from before the current owner's purchase.
Does Illinois tax depreciation recapture differently than the federal government?
Illinois taxes the recaptured amount as part of the seller's overall gain at its flat individual income tax rate, without a separate reduced rate the way the federal system applies to unrecaptured Section 1250 gain.
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