How Depreciation Recapture Tax Works
The tax rate on recaptured deprecation is 25 percent. The best way to understand how it works is through an example. Consider a rental property that you bought 15 years ago for $250,000 and just sold for $350,000. Your analysis showed that $180,000 of the value was in the depreciable buillding and $70,000 was in non-depreciable land. You would have a $100,000 capital gain on the difference between the original purchase price and the selling price, taxable at 15 percent in the 2012 tax year. In addition, the $6,545 per year depreciation that you claimed based on the asset's 27.5 year life, which adds up to $98,175, is taxable at 25 percent as recapture. This leads to a total tax bill on the sale of $39,544, based on $15,000 in gains tax and $24,544 in recapture tax.
Avoiding Depreciation Recapture Tax
You can't avoid the recapture tax by not claiming depreciation. The IRS calculates recapture on the depreciation that you were legally allowed to claim whether or not you actually claimed it. The best way to get out of paying recapture is to use the proceeds from the sale of your rental property to buy another piece of investment property that is the same size or larger. Structuring your transaction as a 1031 exchange and following the IRS's rules for that process lets you carry your proceeds, and your tax basis, forward into a new property without paying depreciation recapture or capital gains taxes.