Depreciation Recapture and 1031 Exchanges: What Real Estate Investors Need to Know

Most real estate investors understand that a 1031 exchange can defer capital gains taxes but far fewer are prepared for depreciation recapture, which can quietly become one of the largest tax bills when selling property.

If you’ve owned an investment property for several years and taken depreciation deductions (as you should), those tax benefits may come back to haunt you unless you plan ahead. Here’s what every investor should know about how depreciation recapture works, how it’s calculated, and how to defer or mitigate it with the right exit strategy.

What Is Depreciation Recapture?

Depreciation recapture is the IRS’s way of “reclaiming” the tax benefits you received from depreciating your property over time. While depreciation lowers your taxable income during ownership, it also reduces your cost basis. That lower basis creates a larger taxable gain when you sell.

The IRS treats the portion of gain tied to depreciation as “recaptured” income, taxed at a flat 25% federal rate, separate from and often higher than long-term capital gains tax rates.

This surprises many investors. Depreciation is an incredible tax benefit while you hold a property but without proper planning, it creates an extra tax layer at exit.

How Depreciation Recapture Is Calculated

Let’s walk through an example:

• Original purchase price: $1,000,000
• Depreciation taken: $250,000
• Adjusted basis: $750,000
• Sale price: $1,260,000
• Total gain: $510,000

The first $250,000 of that gain is depreciation recapture—taxed at 25% = $62,500

The remaining $260,000 is capital gain—taxed at 20% (assuming top federal rate) = $52,000

Total federal tax liability: $114,500 (before state and NIIT)

Note: If your gain is less than the depreciation you claimed, recapture applies only up to the amount of gain. But if your sale price exceeds your adjusted basis, you’ll almost always face some recapture tax.

Deferring Depreciation Recapture Through a 1031 Exchange

One of the most effective ways to defer both capital gains and depreciation recapture is through a 1031 exchange, reinvesting the sale proceeds into another qualifying “like-kind” investment property.

If structured correctly, a 1031 exchange allows you to defer taxes and keep your full equity compounding in a new investment.

Several structures may support a successful 1031 exchange, including:

• Direct property ownership
• Triple Net Lease (NNN) properties
• Tenants-in-common (TIC) arrangements
• Delaware Statutory Trusts (DSTs)
• 721 UPREIT contributions (via DST)

Each of these strategies can be suited for investors looking to reduce active management, generate passive income, or diversify across asset types and markets. DSTs and TICs allow for fractional ownership in institutional-quality real estate, while 721 UPREITs can offer access to a diversified REIT portfolio with potential long-term estate and liquidity benefits.

The right solution depends on your objectives, timing, and tax profile and should be evaluated well before your sale closes.

Final Thoughts

Depreciation is one of the most powerful tools in real estate investing but if you're not careful, it can lead to an unexpected tax hit at the end.

Understanding how depreciation recapture works is essential for any investor planning to exit a property. With proper planning—especially through a well-structured 1031 exchange—you can defer both capital gains and recapture taxes, allowing your equity to keep working for you.

If you're approaching a property sale, work with your tax advisor and a qualified exchange specialist to evaluate your options. The decisions you make before closing can have a lasting impact on your net worth and long-term financial strategy.

General Disclosure