Depreciation Recapture on Commercial Property

39-year straight line

Commercial buildings depreciate over 39 years (versus 27.5 for residential). The annual deduction is smaller, but over a long hold it still adds up to substantial accumulated depreciation.

Same 25% recapture

At sale, the depreciation you claimed is recaptured as unrecaptured Section 1250 gain, taxed at up to 25% — the same cap that applies to residential.

Cost segregation complicates it

Commercial owners often use cost segregation, which creates Section 1245 components recaptured at ordinary rates. Model both pieces before selling.

A worked example

Suppose you bought an office building in 2013 for $2,000,000, allocating $1,600,000 to the building and $400,000 to land (land is never depreciable). Over 39-year straight-line MACRS, the building throws off roughly $41,000 a year. By the time you sell in 2026 — about 13 years later — you've claimed close to $533,000 of accumulated depreciation.

Your original basis of $2,000,000 minus $533,000 of depreciation leaves an adjusted basis of about $1,467,000. If you sell for $2,600,000 (net of selling costs), your total gain is roughly $1,133,000. Of that, the first $533,000 — the depreciation you took — is unrecaptured Section 1250 gain taxed at up to 25% (about $133,000). The remaining $600,000 of appreciation is long-term capital gain taxed at 0/15/20%. At 20%, that's another $120,000, before any state tax or the 3.8% net investment income tax.

Step by step: calculating the recapture

1. Find your adjusted basis. Start with your original cost (purchase price plus capitalized improvements and certain closing costs), then subtract all depreciation allowed or allowable.

2. Compute total gain. Amount realized (sale price minus selling costs) minus adjusted basis.

3. Split the gain. The portion up to your total straight-line depreciation is unrecaptured Section 1250 gain (max 25%); any cost-segregated Section 1245 components are recaptured first at ordinary rates. Whatever remains is regular long-term capital gain.

4. Layer on other taxes. Add the 3.8% NIIT if your income is high enough, plus state income tax, which most states apply to the whole gain with no special cap.

NIIT and state tax stack on top

The 25% figure is a federal cap on the depreciation slice only. High-income sellers also owe the 3.8% net investment income tax under Section 1411 on gain from passive real estate. And most states tax the entire gain, recapture included, as ordinary income — California, for instance, has no preferential capital gains rate. In a high-tax state, an investor's all-in rate on the recapture portion can approach or exceed 30%.

Ways to defer or reduce it

A 1031 like-kind exchange defers both the recapture and the capital gain if you roll the proceeds into replacement real estate of equal or greater value. An installment sale under Section 453 can spread the capital-gain portion over years — but note that depreciation recapture is generally taxed in full in the year of sale, not spread out. Holding until death gives your heirs a stepped-up basis that can erase the deferred tax entirely. Charitable strategies and opportunity-zone reinvestment are other tools worth modeling.

Common mistakes

Forgetting land isn't depreciable — only the building and improvements generate recapture. Assuming recapture disappears if you never claimed depreciation — the IRS taxes it on depreciation "allowed or allowable," so you owe it either way (file Form 3115 to catch up missed deductions before selling). Overlooking cost-segregated 1245 components, which are recaptured at your ordinary rate, not the 25% cap. And ignoring state tax and NIIT, which can add ten or more points to the effective rate.

Reporting the sale

Commercial real estate sold at a gain is reported on Form 4797, Sales of Business Property. Section 1250 real property is generally reported in Part III (which computes any ordinary recapture) and Part I for the Section 1231 gain, and the unrecaptured Section 1250 gain flows to the Unrecaptured Section 1250 Gain Worksheet in the Schedule D instructions, where the 25% rate is applied. Keep your depreciation schedules — the accumulated amount drives the whole calculation.

Section 1231 netting and the loss lookback

Gain on business real estate held over a year is Section 1231 gain, which gets favorable treatment: net 1231 gains are taxed as long-term capital gain, while net 1231 losses are fully deductible against ordinary income. But watch the five-year lookback rule: if you deducted net 1231 losses in the prior five years, an equal amount of this year's 1231 gain is recharacterized as ordinary income. The unrecaptured Section 1250 gain sits inside this framework — first the depreciation slice is capped at 25%, then the netting rules apply to the rest.

Partial dispositions and improvements

Over a long hold you likely capitalized roof replacements, HVAC units, tenant improvements, and other components, each on its own depreciation schedule. When you sell the whole building, all of those accumulated deductions are swept into the recapture calculation. If you replaced a component earlier and made a partial disposition election, you'd have already recognized the loss on the retired part and stopped depreciating it — which keeps your basis and recapture cleaner at final sale. Keep component-level records so nothing is double-counted.

Freeing up suspended passive losses

Commercial rentals are usually passive activities, and many owners carry suspended passive losses they couldn't deduct in prior years because they lacked passive income. A fully taxable sale of the entire interest to an unrelated party generally releases those suspended losses, which can offset the gain — including the recapture and capital-gain portions. For an investor sitting on years of suspended losses, this can dramatically cut the net tax owed on a sale, so tally them before you model the transaction.

Timing the sale to manage brackets

Because the capital-gain portion is taxed at 0/15/20% depending on taxable income, and the 3.8% NIIT and the unrecaptured 1250 rate interact with your bracket, when you sell matters. Selling in a lower-income year, spreading gain with an installment sale (remember recapture is still due up front), or pairing the sale with a large deductible expense or charitable gift can lower the effective rate. Coordinate a big commercial sale with your CPA before signing — a few months' timing can be worth real money.

Depreciation you didn't claim still counts

It bears repeating for commercial owners who self-managed their books: recapture is computed on depreciation allowed or allowable. If you underclaimed or skipped depreciation over the years, the IRS still treats you as having taken it when computing your adjusted basis and recapture — you get the tax hit without ever having gotten the deductions. The fix is to file Form 3115 to claim the missed depreciation as a Section 481(a) catch-up adjustment before you sell, so at least you capture the deductions you're going to be taxed on anyway.

Withholding and estimated tax on a big sale

A large commercial sale can create a tax bill far bigger than your normal withholding covers, exposing you to underpayment penalties. Plan to make a quarterly estimated payment in the quarter you close. If you're a nonresident of the state where the property sits, the state may require the closing agent to withhold a percentage of the sale price at closing (a nonresident real-estate withholding), which you later reconcile on that state's return. Coordinate with your closing agent and CPA so the cash is set aside and the estimates are right.

Partial deferral when a 1031 isn't complete

You don't have to defer all or nothing. If you do a 1031 but pull some cash out or trade down in value, the shortfall is boot, and boot is taxable — with recapture generally coming out first. In practice, the IRS treats the taxable portion of a partial exchange as triggering your unrecaptured Section 1250 gain before your remaining capital gain. So an investor who exchanges into a cheaper building can find that the taxable slice is the high-taxed recapture, not the 15–20% capital gain they expected. Model the boot carefully before agreeing to trade down.

Keeping the records that drive the math

Everything about recapture flows from your basis and depreciation history, so recordkeeping is the quiet key. Hold onto the closing statement from purchase, the land/building allocation and its support, every capitalized-improvement invoice, your annual Form 4562 depreciation schedules, and any cost segregation study and its component schedules. Decades can pass between purchase and sale; reconstructing depreciation after the fact is painful and error-prone. Good records also let you claim missed depreciation via Form 3115 and defend your allocation if the IRS questions the split.

Ground leases and leasehold improvements

Some commercial investors own the improvements but lease the land underneath (a ground lease), or hold a leasehold and build out the space. Leasehold improvements and qualified improvement property carry their own recovery periods and their own depreciation to recapture when the interest is sold or the lease ends. If you own a building on leased land, the building still depreciates over 39 years and still generates Section 1250 recapture, even though you never owned the dirt. Track each interest separately so the recapture calculation captures every schedule.

Frequently asked questions

Sources

• IRS Topic No. 409 — Capital Gains and Losses
• IRS Publication 544 — Sales and Other Dispositions of Assets
• IRS Publication 946 — How to Depreciate Property

Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.

Related

• Depreciation Recapture Calculator
• Cost Segregation Calculator