By Omar Larios, CPA, Senior Accountant at Blue & Co.

One of the most popular tax law updates from the One Big Beautiful Bill (OBBB) for real estate investors and business owners was the restoration of 100 percent bonus depreciation. This became even more valuable for real estate investors who took advantage of cost segregation studies, allowing certain portions of newly purchased real estate to be deducted immediately. The benefits of 100 percent bonus depreciation were highlighted all over social media, websites, and by CPA firms, but an important aspect of tax law applicable to real estate investors was rarely mentioned: depreciation recapture.

Depreciation Recapture

Once you decide to sell an asset, such as a rental property, depreciation recapture is required to collect taxes on a portion of the gain related to the depreciation that was previously taken on that asset. When looking to sell an investment property, many investors may assume that the favorable capital gains rates of zero, 15, or 20 percent apply, but that is not always the case. In addition to the tax rates below, it is also important to note that high-income earners may be subject to the net investment income tax of 3.8 percent on the gain.

Types of Property Subject to Depreciation Recapture

Depending on the type of asset an investor is selling, the depreciation recapture tax rate will differ.

• Section 1245 Property: Tangible personal property subject to depreciation, such as furniture, equipment, or appliances.
  • Depreciation recapture is generally taxed at ordinary income tax rates up to 37 percent.
• Section 1250 Property: Depreciable real property that is not section 1245 property, such as buildings, decks, roofs, qualified improvement property, and other structural components.
  • Depreciation recapture on unrecaptured 1250 gain is generally taxed at a maximum of 25 percent. This is most common in modern residential and commercial rentals that use straight-line depreciation.

While less common and typically involving older properties, depreciation recapture on recaptured Section 1250 gain, which is the portion of gain attributable to additional depreciation exceeding the straight-line amounts, is generally taxed at ordinary rates.

Amount Subject to Depreciation Recapture

To estimate the amount that will be subject to depreciation recapture, it is important to understand how much depreciation has been taken to date. Starting with the adjusted basis (cost basis minus allowable depreciation), if an investor plans to sell an asset and the proceeds are lower than the adjusted basis, there will be no depreciation recapture since the asset is being sold at a loss. However, if the proceeds are higher than the adjusted basis, there will be a gain, and the amount of depreciation recapture needs to be determined.

As a quick example, if an investor sells a building (Section 1250 property) for a gain of $50,000 and has claimed $30,000 of the straight-line depreciation allowed on the building, the $30,000 is the unrecaptured Section 1250 gain subject to the maximum 25 percent rate, and the remaining $20,000 gain will be subject to favorable capital gains rates.

What is the Impact of 100 Percent Bonus Depreciation?

Depreciable Section 1245 property assets are some of the most common assets in which investors have taken advantage of 100 percent bonus depreciation. If an investor places a Section 1245 asset into service, claims 100 percent bonus depreciation, then sells that asset two years later at a $5,000 gain, the entire $5,000 will be recaptured and taxed at ordinary tax rates.

Take the same situation for an asset placed in service in 2024 when 60 percent bonus depreciation was in effect. The asset would not be entirely depreciated at the time of sale, so only a portion of the gain would be recaptured and taxed at ordinary tax rates. The remaining gain would be taxed at favorable capital gains rates.

Navigating Depreciation Recapture

There are strategies that allow investors to legally avoid or reduce depreciation recapture upon the sale of their business assets. A few strategies include:

• Expense vs. Capital Asset Identification: Many investors mistakenly capitalize smaller purchases that can be expensed immediately, resulting in depreciation recapture upon sale that could have been avoided by electing to deduct the purchase under the de minimis safe harbor. Common examples of smaller purchases that can be expensed if they are under the applicable threshold are microwaves, stoves, power tools, and ceiling fans.
• Asset Disposals: Many investors will replace a roof, for example, on their newly purchased property and capitalize and depreciate it as a new asset, but they may miss the opportunity to partially dispose of the portion of the building that represented the old roof. By not disposing of the old asset, the investor may forgo the ability to claim a loss in the year of replacement and instead continue to claim depreciation on the old roof. This may increase the depreciation-related gain, subject to the applicable Section 1250 recapture rules, upon the eventual sale of the property.
• 1031 Exchange: A popular strategy among real estate investors that allows them to defer capital gains tax and depreciation recapture on the sale of their Section 1250 assets by rolling the gain into a new investment property. It is important to note that most Section 1245 assets are not eligible for the tax-deferred benefits of Section 1031. This is an essential planning consideration for investors who use the cost segregation strategy when they purchase real estate.

Planning for a Future Sale

There are numerous variables to consider when planning the sale of an investment property. The tax implications may even begin before the property is purchased and will depend on each individual’s situation. There are strategies to help reduce the cost of depreciation recapture that can be implemented during planning for the purchase of a new property, each year the property is in use, in the year of sale, or potentially even afterward.

It is important to have a knowledgeable tax adviser by your side to help you meet your goals while minimizing your tax burden. To explore the most tax-efficient options for your business, please contact your local Blue & Co. advisor for assistance.