Rental property owners depreciate building values over 27.5 years, reducing taxable income annually. Sale triggers recapture of those depreciation deductions as taxable income.
Annual Depreciation and Tax Deductions
Rental properties depreciate for tax purposes even if market value appreciates. If you own a $400,000 rental property (allocate 80% to building, 20% to land = $320,000 building value), you depreciate $320,000 รท 27.5 years = $11,636 annually. This depreciation reduces taxable income, potentially creating tax losses that shelter other income. Over 20 years of ownership, you've deducted $232,720 in depreciation against income, deferring significant taxes.
Depreciation Recapture Upon Sale
When you sell the property, depreciation deductions are "recaptured" and taxed at 25% federal rate (plus state tax, typically adding 5-13.3%). If you sell for $600,000 after deducting $232,720 in depreciation, you owe taxes on both capital gains ($200,000 appreciation) and depreciation recapture ($232,720). Total taxable income is $432,720, creating substantial tax liability. The depreciation benefit comes as ongoing income reduction during ownership; the recapture cost arises upon sale.
1031 Exchanges to Defer Depreciation Recapture
1031 exchanges defer not just capital gains tax but also depreciation recapture. If you exchange instead of selling, no recapture occurs. The depreciation basis carries forward to the replacement property, allowing continued depreciation. This indefinite deferral is one of the greatest 1031 exchange benefits. Investors optimize wealth by continuously exchanging properties, deferring taxes until inheritance, at which point stepped-up basis eliminates the tax burden entirely.