Recapture Tax When You Sell

Depreciation recapture tax is the part of a sale that catches long-term owners off guard most often, precisely because it has nothing to do with how much the property appreciated. Every year an investor claims depreciation on a rental or commercial building near Indianapolis, that deduction lowers taxable income at the time, but it also lowers the property's basis, and at sale the IRS recaptures a portion of that benefit as a separate tax, calculated apart from the ordinary capital gain on appreciation. A property that barely rose in market value can still generate a substantial recapture bill if it was depreciated aggressively over a long hold.

For real property, the recapture rate is capped at 25 percent, applied to the total depreciation claimed over the ownership period, known as unrecaptured Section 1250 gain. This is separate from and generally stacked on top of the standard long-term capital gains rate applied to the remaining appreciation. A seller reviewing a rough estimate that only accounts for the capital gains rate is very likely underestimating the actual tax owed once recapture is added in.

One detail that surprises owners: recapture is calculated on the depreciation the owner was entitled to claim, not just the amount they actually reported on their returns. An investor who owned a rental for years and forgot, or chose, not to claim depreciation deductions still faces recapture on sale as though those deductions had been taken, which makes it worth reviewing several years of past returns with a CPA before assuming a lighter tax picture than the numbers actually support.

Cost segregation studies accelerate depreciation into earlier years by reclassifying parts of a building into shorter-life categories, which reduces taxable income during ownership but increases the eventual recapture exposure at sale. This tradeoff makes sense for an owner planning a long hold or an eventual exchange, but it changes the math meaningfully for an owner who ends up selling sooner than planned, since the accelerated deductions come back due in the form of a larger recapture bill.

A 1031 exchange defers depreciation recapture along with the ordinary capital gain, provided the exchange is structured correctly and the full amount of realized gain, not just the appreciation portion, is rolled into the replacement property. This matters for owners of heavily depreciated buildings, such as an older industrial property near the Plainfield corridor, where recapture can represent a larger share of the total liability than appreciation does. The deferred recapture carries into the new property's basis and comes due only if that replacement is eventually sold outside of another exchange.

Indiana does not carve out a separate lower rate for recaptured depreciation the way federal law caps it at 25 percent; the state taxes the recaptured amount as ordinary income at its flat individual rate, stacked on top of whatever else the seller owes on the standard capital gain. A seller running numbers only against the federal 25 percent cap is missing a real piece of the total bill, and the gap becomes more noticeable on a larger commercial sale where the recaptured amount itself is a large dollar figure. Coordinating the federal and state calculations together, rather than treating the state number as an afterthought, gives a more accurate picture of what a sale actually nets after tax.