Depreciation Recapture in Commercial Real Estate
Key Takeaways
- Depreciation recapture is a deferred tax obligation. It builds quietly every year you claim a depreciation deduction and becomes due when you sell.
- Your recapture exposure is the lesser of your total accumulated depreciation or your total realized gain, taxed at up to 25% for Section 1250 real property (known as unrecaptured Section 1250 gain) and up to 37% for Section 1245 personal property.
- The IRS applies the allowed or allowable rule: if you failed to claim depreciation you were entitled to, your basis is reduced as if you had, meaning you can owe recapture tax on deductions you never took.
What Is Depreciation Recapture?
Depreciation recapture is a federal tax applied when you sell a depreciable asset for more than the adjusted basis. It requires you to pay taxes on the portion of your gain that corresponds to the depreciation deductions you took on the property during your hold.
Whether you own an industrial property, retail strip, office, or any other kind of commercial asset, you can deduct a portion of the building's value annually as commercial real estate depreciation to reduce your taxable income every year of your hold. Depreciation recapture is how the IRS collects the deferred taxes on the benefits you received from depreciation.
When you sell, the IRS compares your sale price to your adjusted basis, which is your original purchase price minus all the accumulated depreciation you claimed. The IRS then taxes the portion of your gain equal to the depreciation you claimed. However, that portion is taxed as recaptured depreciation, not long-term capital gains.
Whether you follow the depreciation life of a commercial building set by straight-line depreciation or choose to take advantage of accelerated depreciation for early-hold savings, depreciation recapture will apply when you sell. For investors with long hold periods that amount can be sizeable, and it grows every year you claim the deduction.
Understanding your recapture exposure before you buy, not just before you sell, is one of the clearest separators between investors who plan and those who react.
How Do You Find Your Depreciation Recapture Exposure?
Compare your total accumulated depreciation to your total realized gain, and the lesser is your depreciation exposure.
The first step in calculating depreciation recapture is to find your adjusted basis by adding your purchase price and any capitalized expenses, then subtracting your accumulated depreciation. Compare that number to your total gain at sale. The lesser of the two is the recapture amount the IRS will tax.
Here's what that looks like in a hypothetical commercial real estate scenario:
Say an investor chose to buy a retail property for $2 million. The land is valued at $500,000, which leaves the asset's depreciable basis at $1.5 million. Using a 39-year, straight-line depreciation schedule, the annual depreciation deduction is $38,462. After a 10-year hold, accumulated depreciation is $384,620.
After that 10 years, if the investor sold the property for $2.8 million, the adjusted basis would be just over $1.6 million, for a total gain of approximately $1.2 million and a remaining capital gain of $800,000. The $384,620 in recaptured depreciation is taxed at a maximum federal rate of 25%. However, high-income investors may also owe the 3.8% Net Investment Income Tax, bringing the effective federal rate on recaptured depreciation even higher. The remaining $800,000 is taxed at long-term capital gains rates.
| Sale Price | $2,800,000 |
| Adjusted Basis | $1,615,380 |
| Total Gain | $1,184,620 |
| Depreciation Recapture (taxed up to 25%) | $384,620 |
| Remaining Capital Gain | $800,000 |
Hold period can significantly impact your depreciation exposure. Every year you hold an asset adds to your accumulated depreciation balance and your taxable amount when you eventually exit.
What Is Section 1250 vs. Section 1245 Recapture?
Section 1250 applies to real property, while Section 1245 applies to personal property, and they are taxed at different rates.
Most commercial properties contain both real and personal property, which means most sales involve both types of recapture. The tax rate difference between these two buckets is why your depreciation structure at acquisition affects your recapture bill at sale.
This chart shows the main differences between Section 1250 and Section 1245 recapture:
| Recapture Type | Section 1250 | Section 1245 |
|---|---|---|
| Property Type | Real property (building structure, long-lived improvements) | Personal property (equipment, fixtures, reclassified components) |
| Depreciation Schedule | 27.5 years (residential) or 39 years (commercial) | 5, 7, or 15 years |
| Max Federal Recapture Rate | 25% (on unrecaptured Section 1250 gain) | Up to 37% |
Using a commercial cost segregation study and bonus depreciation strategy that front-loads deductions on Section 1245 assets produces larger early-hold tax savings. However, it also concentrates recapture exposure in the higher, ordinary rate bucket.
Knowing how your depreciation was structured directly affects how your recapture liability breaks down at sale.
What Is the 'Allowed or Allowable' Rule for Depreciation Recapture?
At exit, the IRS reduces your adjusted basis by the greater of the depreciation you claimed or the depreciation you were entitled to.
Under a longstanding IRS rule (IRC § 1016(a)(2) and Treasury Regulation § 1.1016-3) , if you failed to claim depreciation deductions you were entitled to, the IRS treats your basis as if you had claimed them anyway. The result is a lower adjusted basis, a larger taxable gain, and a higher recapture bill at sale, even if you never took all the deductions you could have.
It's a common mistake, and one investors can miss until after closing, when it's too late to rectify. Having a CPA audit your depreciation schedule before you list the property is one of the higher-value pre-sale steps you can take. Once you buy a commercial property, tracking capital expenses and filing Form 3115 are the two practical tools for closing the gap between what you claimed and what was allowable.
To avoid missing deductions, you can first determine your CapEx strategy early in your hold and keep track of your capital vs. operating expenses throughout to ensure you claim all available depreciation benefits.
Then, if later in your hold you realize you missed taking deductions you were entitled to, you can file Form 3115 with your tax return for the year of the accounting method change. This allows you to catch up on missed depreciation deductions without amending prior returns, but it must be filed before you sell. Doing so restores the tax benefit you should have been taking, which partially offsets the recapture exposure.
How Do Cost Segregation Studies Affect Depreciation Recapture Exposure?
A cost segregation study accelerates your depreciation deductions but it also accelerates your recapture exposure at sale.
A cost segregation study reclassifies components of a commercial building from 39-year real property into shorter-lived personal property categories. That accelerates your depreciation deductions significantly in early years, but the tradeoff is that the reclassified assets are taxed as Section 1245 property. That means the IRS taxes them at ordinary income rates at recapture, which can go above the 25% cap that applies to Section 1250 real property.
A cost segregation study can generate meaningful early-hold tax savings, but it's important to model recapture exposure at various exit points before committing to an accelerated depreciation schedule, particularly if you won't have a deferral strategy like a 1031 exchange available at exit.
How Can You Reduce or Defer Depreciation Recapture?
You can defer or eliminate depreciation recapture with a 1031 exchange, QOZ investment, or charitable remainder trust.
There is no one-size-fits-all approach to reducing depreciation recapture liability. However, some widely used approaches include a 1031 exchange, qualified opportunity zone investment, using a charitable remainder trust, and holding until death.
The right method is the one that best aligns with your goals and exit strategy, whether you plan a like-property exchange or plan to list your commercial property for auction. A 1031 exchange suits investors who want to stay in the market. A QOZ investment suits those with longer time horizons who want to redeploy into a new asset class. A CRT and holding until death both suit investors prioritizing income and wealth transfer over liquidity.
This chart breaks down some of the key elements of all four strategies:
| Strategy | Recapture Effect | Tradeoff |
|---|---|---|
| 1031 Exchange | Defers recapture and capital gains tax into replacement property | Strict IRS timelines: 45 days to identify, 180 days to close. Recapture liability carries forward. |
| Qualified Opportunity Zone | Defers entire taxable gain (including recapture) until QOZ investment is sold; eliminates recapture after 10+ year hold | Must invest within 180 days of sale. Gain deferred for five years from investment date. Appreciation excluded from tax after 10+ year hold. |
| Charitable Remainder Trust | Avoids immediate recapture recognition; hold until death resets basis for heirs | Irrevocable. Remainder passes to charity. Requires estate planning counsel. |
| Holding Until Death | Eliminates recapture entirely via stepped-up basis reset for heirs | Requires holding the asset indefinitely. Stepped-up basis rules could change under future legislation. |
1031 Exchange
A 1031 exchange is the most widely used recapture deferral tool. Under IRC Section 1031, reinvesting sale proceeds into a like-kind replacement property defers both capital gains and depreciation recapture taxes entirely. The IRS requires 45 days to identify the replacement property and 180 days to close.
Qualified Opportunity Zone
Investing your taxable gain, including your recaptured depreciation, into a qualified opportunity zone (QOZ) fund within 180 days defers that gain for five years from the date of investment. If you hold for more than 10 years, the QOZ investment excludes appreciation from tax entirely and eliminates any depreciation recapture liability at sale. The One Big Beautiful Bill Act, signed July 4, 2025, made the QOZ program permanent, though zone designations are subject to decennial renewal. Consult a tax advisor to confirm your target fund falls within a currently designated zone.
CRT or Hold Until Death
A charitable remainder trust allows an investor to contribute appreciated property, avoid immediate gain and recapture recognition, and receive an income stream for life.
Holding until death triggers a stepped-up basis for heirs under current law that eliminates the accumulated recapture liability entirely, though the strategy has been the subject of proposed reforms.
The right choice depends on whether you need income during your lifetime or a clean basis reset for your heirs.
If you're weighing a sale or exchange, browsing available commercial listings in your market can help you gauge replacement property options before you commit to a strategy.
Commercial Real Estate For Sale
Frequently Asked Questions
If I completed a cost segregation study early in my hold period, how do I calculate how much additional recapture exposure I created compared to straight-line depreciation?
The additional recapture exposure from a cost segregation study is the difference between what you actually claimed under the accelerated schedule and what you would have claimed under 39-year straight-line depreciation for the same hold period. For example, if straight-line depreciation would have produced $200,000 in deductions over five years but your cost segregation study generated $600,000, the $400,000 difference represents additional Section 1245 recapture exposure taxed at ordinary income rates, not the 25% cap that applies to Section 1250 property. Ask your CPA to pull your full depreciation schedule before you list the property to get a precise figure.
How does depreciation recapture work when a property is inherited, and does the stepped-up basis eliminate the prior owner's accumulated depreciation?
When a CRE investor inherits a property, the tax basis resets to the fair market value on the date of the decedent's death under stepped-up basis rules. The accumulated depreciation claimed by the original owner is effectively wiped out, and the heir starts with a fresh basis. If the heir sells immediately, there is typically little to no taxable gain and no recapture. However, if the heir continues holding and claiming depreciation from the stepped-up basis, they begin building their own recapture liability going forward. One common mistake: heirs who continue using the decedent's original depreciation schedule rather than resetting to the stepped-up basis can end up paying recapture tax on depreciation they never actually benefited from. A CPA should formally establish and document the stepped-up basis at the time of inheritance.
