Depreciation Recapture in a 1031 — Deferred, Not Forgiven

Every year of depreciation you’ve deducted is a future tax bill at up to 25% — usually the biggest single line in a rental seller’s tax exposure. The good news: a proper 1031 exchange defers recapture right alongside capital gain. The details reward attention.

What recapture is

Depreciation reduces basis as you deduct it; on sale, the gain attributable to that reduction is “unrecaptured §1250 gain,” taxed at up to 25% instead of capital-gains rates (plus state, plus possibly NIIT). Two decades of deductions on a $1M building can stack $300K+ of recapture exposure — often exceeding the appreciation-driven gain itself.

How the exchange handles it

A full exchange recognizes no gain, so recapture waits inside the carried-over basis — deferred as long as the chain continues, and erased entirely if the chain reaches the basis step-up at death. This is the underappreciated half of “swap till you drop”: people picture deferring appreciation, but the recapture deferral is frequently the larger number.

Where it leaks out early

Boot triggers recognition — and recapture comes out first, at the 25% rate, before any dollar of gain gets capital-gains treatment. A $100K cash-out from a heavily depreciated property is mostly a 25%-rate event, a surprise for sellers expecting 15-20%. The historical trap of personal-property recapture (§1245 items in a building exchanged pre-2018) has mostly aged out, but cost-segregated properties deserve a specific CPA look: segregated 5- and 7-year components carry §1245 character that real-property exchanges don’t automatically shelter (VERIFY treatment per study and year).

Planning posture

Depreciate fully and unapologetically — deductions now, deferral later, is winning sequencing even with recapture waiting. Just keep the eventual exit exchange-shaped: the sellers who feel recapture’s full 25% are the ones who take cash in the exact year their depreciation history was largest. Model both paths before listing; it’s a ten-minute calculator conversation with your CPA’s numbers.