Depreciation Recapture Tax Rate (25% Rule)

The depreciation recapture tax rate determines how much of the benefit from prior depreciation deductions is effectively clawed back by the IRS on disposition. An investor who deducted $400,000 of depreciation at a 37% marginal rate saved $148,000 in taxes. At exit, if that $400,000 is recaptured at 25% or 37% is the difference in planning assumptions that can change the net economic outcome of a study.

Getting the rate right also matters for modeling hold period economics. The longer the hold, the longer the early deductions have to compound at after-tax returns before the recapture obligation comes due. The rate at exit is what determines the dollar cost of that future obligation, so assumptions about future ordinary income rates directly affect the present-value calculation.

Section 1245 of the Internal Revenue Code applies to personal property and certain other depreciable assets. When property classified under Section 1245 is sold at a gain, the accumulated depreciation is recaptured as ordinary income, not as capital gain. This distinction is significant because ordinary income rates can reach 37% at the federal level for high-income taxpayers.

In the context of cost segregation, the components most commonly subject to Section 1245 recapture are the 5-year and 7-year MACRS personal property assets (such as carpeting, specialized electrical, and certain fixtures) and 15-year land improvements (such as parking lots, landscaping, and site utilities). All depreciation taken on these components is recaptured at ordinary income rates, and there is no 25% cap.

If bonus depreciation was applied to these components in Year 1, the basis is zero. The entire allocated cost basis is recovered depreciation, and any amount realized on those components at sale is Section 1245 recapture taxed at ordinary rates.

Unrecaptured Section 1250 gain is a specific tax category that applies to the accumulated straight-line depreciation taken on real property. For real property depreciated under MACRS (27.5-year residential or 39-year nonresidential), all depreciation is straight-line. As a result, there is no depreciation in excess of straight-line, meaning the traditional Section 1250 recapture at ordinary rates rarely applies under current law.

Instead, the accumulated MACRS depreciation on the building component is classified as unrecaptured Section 1250 gain, which is taxed at a maximum rate of 25% for individual taxpayers. For investors in the 10% or 12% ordinary income brackets, the rate is their actual marginal rate, not 25%. The 25% rate is a ceiling, not a floor.

Unrecaptured Section 1250 gain is distinct from the Section 1231 gain that represents appreciation above the original purchase price. Section 1231 gain qualifies for long-term capital gain rates of 0%, 15%, or 20%, making it the most favorable gain category on real property dispositions.

On the tax return, gain from the sale of real property is reported on Form 4797 (Sales of Business Property) and Schedule D. The different gain categories are computed separately and carried through to the appropriate line items. Unrecaptured Section 1250 gain is reported on the Unrecaptured Section 1250 Gain Worksheet in the Schedule D instructions.

Taxpayers do not simply choose which rate to apply. The gain ordering rules in the tax code determine how much falls into each category based on accumulated depreciation records. This is why maintaining detailed depreciation schedules, which a cost segregation study provides, is important for accurate tax reporting at exit.

For investors evaluating whether to proceed with a study before a sale, the tax rate on recaptured depreciation is a key input. See the guide on minimizing recapture tax to understand what options are available to reduce the effective rate impact.

Federal depreciation recapture tax rates are only part of the picture. Most states impose income taxes on gain recognized from real property sales, and many do not have preferential capital gain rates. Some states tax all gain as ordinary income, including amounts that qualify for long-term capital gain or the 25% cap at the federal level.

The Net Investment Income Tax of 3.8% can apply to net investment income, which may include gain from property dispositions depending on the taxpayer's participation level and income. For passive investors, NIIT often applies to all gain components, adding to the effective rate on recapture and appreciation.

In high-tax states, the combined federal and state rate on Section 1245 recapture can approach or exceed 50% for high-income taxpayers. This is a key reason why recapture planning strategies are important, particularly for properties with large amounts of reclassified personal property.

While the statutory rates cannot be changed, investors can influence which rate applies to which dollar through timing and structure decisions.

• 1031 exchange: Defers all gain recognition, including Section 1245 recapture and unrecaptured Section 1250 gain. The recapture carries to the replacement property and is recognized at the rate in effect in the year of eventual sale.
• Income timing: If the taxpayer's ordinary income rate will be lower in a future year (due to retirement, business changes, or rate law changes), deferring the sale to that year can reduce the effective rate on Section 1245 recapture.
• Opportunity zone investment: Investing the gain in a Qualified Opportunity Fund can defer and partially reduce the gain recognition, including the recapture component, under specific program rules.

For a full review of exit strategies when selling a property that has been through a cost segregation study, see the dedicated guide. The main cost segregation guide provides additional context on how depreciation interacts with property planning.