Depreciation Recapture Tax When You Sell

Depreciation recapture is the part of a sale that landlords tend to underestimate the most, because it's easy to think of the deductions taken over the years as free money that never comes back around. It doesn't work that way. Every dollar of depreciation claimed against a New York rental or commercial building lowers the property's basis, and lower basis means a larger taxable gain when the property eventually sells, with a specific slice of that gain taxed under its own separate rules.

Depreciation deductions reduce taxable income during the years a property is held, on the theory that the building's value declines over time due to wear. When the property is sold for more than its depreciated basis, the IRS treats the portion of the gain equal to the depreciation claimed as recapture, taxed federally at a rate capped at twenty-five percent, distinct from the standard long-term capital gains rates that apply to the remaining gain above that amount.

The logic is that the depreciation deductions were a benefit received during ownership, and recapture claws back the tax advantage of those deductions once it becomes clear the building didn't actually lose the value the depreciation schedule assumed.

A common misconception is that recapture only applies to depreciation actually claimed on past tax returns. In practice, the IRS calculates recapture based on depreciation allowed or allowable, meaning an owner who was eligible to depreciate a property but never claimed it still faces recapture as if they had. Skipping depreciation doesn't avoid the eventual tax; it just means the owner paid more tax during the ownership years without getting the offsetting deduction, then still owes recapture at sale. Owners in this position should talk to a CPA about filing a change in accounting method to claim missed depreciation before selling, rather than losing the deduction entirely.

The federal system carves recapture out as its own category with its own capped rate. New York does not. At the state level, both the recapture portion and the remaining capital gain are taxed together as ordinary income, without the federal cap. For a seller in a high New York bracket, this means the state portion of the recapture bill can end up taxed at a higher rate than the federal portion, which is the reverse of what a lot of sellers assume going in.

A properly structured 1031 exchange defers both the capital gain and the recapture together, rather than requiring the recapture to be settled at sale while only the gain above it gets deferred. This is one of the more valuable aspects of exchanging out of a heavily depreciated New York property, since older buildings with years of accumulated depreciation often carry recapture bills that are large relative to the total gain, and deferring that piece specifically can be the difference between a transaction that pencils out and one that doesn't after tax.