Depreciation Recapture Briefing

Depreciation recapture is one of the most misunderstood costs of selling investment real estate, and it does not disappear simply because a Section 1031 exchange defers the underlying capital gain. Recapture applies to the accumulated depreciation an investor has claimed on a property over the holding period, and unrecaptured Section 1250 gain attributable to real property depreciation is generally taxed at a federal rate of up to twenty five percent when it is ultimately recognized, separate from the standard long term capital gains rate that applies to appreciation. A properly structured exchange defers recapture along with the rest of the gain, but investors approaching a sale in Phoenix, AZ benefit from understanding the exposure before it becomes relevant, particularly if a future transaction does not qualify for full deferral.

Reviewing the Depreciation History

Our briefing begins with a review of the property's depreciation schedule and the cost recovery method used throughout the holding period, since commercial real estate is typically depreciated over thirty nine years while residential rental property uses a twenty seven and one half year schedule, and any accelerated depreciation claimed on components such as personal property or land improvements can carry different recapture treatment under Section 1245 rather than Section 1250. We summarize the total depreciation claimed to date and project the recapture exposure under a few different scenarios, including a fully deferred exchange, a partially deferred exchange with some boot recognized, and a fully taxable sale, so the investor can see how much of their potential exposure the exchange strategy is actually addressing. This scenario planning also incorporates Arizona's flat individual income tax rate, which applies to any recognized recapture income in addition to the federal Section 1250 rate, giving investors a combined picture of total exposure rather than a federal only estimate that understates the real cost of a taxable event.

Coordinating With CPAs and Form 8824

We do not provide tax advice ourselves; our role is to prepare organized data and facilitate communication with the investor's own certified public accountant, who determines the final recapture calculation and reporting position. Meeting notes from CPA coordination sessions are documented so investors have a clear record of what was discussed and decided, and a checklist aligns Form 8824 entries with the intermediary's closing statements, since accurate reporting of relinquished and replacement property basis is essential to calculating recapture correctly on a partially deferred exchange. It is worth noting that land itself is not depreciable and therefore does not carry recapture exposure, but improvements and structures built on that land can trigger recapture when they are sold or exchanged, a distinction that matters for investors who have made significant capital improvements during their holding period. A post closing checklist confirms the documentation required for filing is complete, including prior depreciation schedules, settlement statements from both the relinquished and replacement transactions, and any boot recognized, so the CPA has everything needed to prepare an accurate Form 8824 without requesting additional records after the filing deadline is already approaching.

Investors who have owned a Phoenix property for many years sometimes carry a fully or nearly fully depreciated basis, which means a disproportionate share of any eventual sale proceeds represents recapture rather than appreciation gain, a distinction that matters because the two categories are taxed differently even within the same transaction. We walk through this basis history carefully, since an investor who assumes their entire gain will be taxed at long term capital gains rates can be surprised to learn that a significant portion is instead subject to the higher unrecaptured Section 1250 rate once a sale or a partially taxable exchange occurs. For investors who have refinanced the property one or more times during ownership, we also clarify that refinancing proceeds themselves are not taxable and do not trigger recapture, since recapture is only recognized upon an actual sale or disposition, a point that is sometimes confused with the separate, and unrelated, tax treatment of loan proceeds. Where a property includes a component depreciated on an accelerated schedule under a cost segregation study, we identify that portion separately in the briefing, since accelerated components can carry different, and sometimes more immediate, recapture exposure than the building's primary structure.