Real estate can be a great way for physicians to build long-term wealth, either by owning their medical office building or investing in rental properties. Along the way, depreciation offers valuable tax benefits by allowing you to deduct a portion of the property’s cost each year.
However, many medical professionals are surprised to learn that these deductions can lead to a tax bill when they eventually sell the property. This is due to depreciation recapture, which can affect the cash you ultimately keep after closing.
Understanding how depreciation recapture works helps you plan ahead, avoid unexpected tax liabilities, and look for opportunities to reduce or defer the tax impact.
What is depreciation recapture?
Depreciation recapture is a federal tax provision that requires you to “pay back” part of the tax benefit you received from claiming depreciation deductions over the years you owned a property.
When you sell a building, whether it’s a medical office or a rental, the IRS compares your adjusted basis (your original cost minus the depreciation you claimed or could have claimed) to your selling price. If the property sells for more than its adjusted basis, the portion of the gain attributable to prior depreciation is taxed differently than regular long-term capital gains.
When you sell depreciable real property (Section 1250 property), the portion of your gain attributable to straight-line depreciation is called “unrecaptured Section 1250 gain” and is taxed at a maximum federal rate of 25%.
When you recapture depreciation on Section 1245 property, which includes assets like equipment and certain non-structural items, it is taxed at your ordinary income tax rate, which can be up to 37%. These rates are generally higher than the long-term capital gains tax rate that applies to the rest of your gain, which can range from 0% to 20%, depending on your total taxable income.
If you’ve owned the property for several years, and especially if you’ve claimed accelerated depreciation on Section 1245 property or participated in a cost segregation study, you may find that depreciation recapture represents a large portion of your taxable gain.
How does depreciation recapture affect the sale of real estate?
Depreciation recapture generally doesn’t apply until you decide to sell the property. If you’ve owned and depreciated the property for several years, you may have a substantial capital gain.
Most physicians think of their profit as simply the difference between the purchase price and the sale price, but the IRS evaluates transactions differently. This is where many physicians get surprised. Because depreciation reduced your taxable income over the years you owned the property, the federal government treats part of your gain as a recovery of those prior tax benefits.
Here are a few situations in which you might run into depreciation recapture:
Selling a medical office you’ve owned for a decade or more
Many real estate owners depreciate their buildings every year without giving much thought to the long-term effects. After a decade or more, these deductions really add up. When you sell, the IRS requires you to recapture the depreciation.
Even if the building didn’t significantly appreciate in value, the accumulated depreciation can create a taxable gain.
Selling a rental home or small portfolio used for passive income
Rental properties often produce steady cash flow, in part because depreciation shelters a portion of that income from current taxation. However, those same deductions reduce your basis in the property.
For long-held rentals, the recapture component can be substantial.
Exiting real estate after years of ownership
Some physicians scale back their real estate investments as they near retirement. In this transition, selling multiple properties at once may trigger large recapture obligations that reduce the net cash available for reinvestment or personal use.
Depreciation recapture example
To understand how depreciation recapture works in real life, let’s look at an example. Say you’re preparing to sell a medical office building you purchased 15 years ago for $1,200,000.
Of that amount, $300,000 was allocated to land (not depreciable) and $900,000 to the building (depreciable). Over 15 years, you claimed $500,000 in total depreciation. You’re planning to sell the building for $1,600,000, after closing costs.
Here’s how to calculate the estimated tax liability on the sale:
Step 1: Calculate your adjusted basis
Your adjusted basis is your original purchase price of the building (but not the land) minus the depreciation you claimed.
$900,000 (depreciable building basis) – $500,000 (depreciation taken) = $400,000 adjusted building basis
Then, add back the non-depreciable land:
$400,000 (adjusted building basis) + $300,000 (land) = $700,000 total adjusted basis
Step 2: Calculate your total gain
$1,600,000 (sale price) – $700,000 (total adjusted basis) = $900,000 total gain
Step 3: Separate depreciation recapture from capital gain
Of the $900,000 gain, $500,000 attributable to prior straight-line depreciation is taxed at a maximum federal rate of 25%. The remaining $400,000 is long-term capital gain, taxed at the applicable long-term capital gains rate.
Step 4: Estimate the tax impact
Federal tax on depreciation recapture:
$500,000 x 25% = $125,000
Federal tax on remaining long-term capital gain (assuming a 20% tax rate):
$400,000 x 20% = $80,000
Total estimated federal tax:
$125,000 + $80,000 = $205,000
So even though your building appreciated by $400,000, an additional $500,000 of gain exists solely because depreciation reduced your basis over time. That $500,000 doesn’t feel like “profit” in the everyday sense, but it is taxable due to recapture rules.
Understanding this distinction helps you anticipate your actual after-tax proceeds and plan accordingly before selling the property.
How to reduce or defer tax on depreciation recapture
Depreciation recapture is mandatory when you sell a depreciated property, but there are strategies to reduce or defer the associated tax. If you anticipate a future sale, you should discuss your options with a qualified tax advisor well before listing the property.
Complete a 1031 exchange (like-kind exchange)
A 1031 exchange allows you to defer capital gains and depreciation recapture by essentially exchanging one investment property for another qualifying property. This strategy doesn’t erase the tax. It just defers it until you eventually sell the replacement property.
To benefit from a 1031, you must follow some important rules. For example, the replacement property must be real property, held for investment or business use. For example, you could exchange a rental house for a commercial building, but you couldn’t exchange your medical office building for a vacation home.
You also have to follow strict timelines. You must identify potential replacement properties within 45 calendar days of the sale and close on the purchase of one or more replacement properties within 180 calendar days.
Plus, you can’t receive the sales proceeds directly. Instead, you must work with a qualified intermediary who holds the funds in escrow and facilitates the exchange.
Use a Delaware Statutory Trust (DST) for hands-off ownership
A DST is an investment structure that qualifies as like-kind property for 1031 exchanges. It allows you to exchange into fractional ownership of professionally managed commercial real estate without taking on day-to-day landlord responsibilities.
A DST may be a good option if you want to defer capital gains and depreciation recapture, but no longer wish to actively manage real estate.
DSTs are sold as securities, so you must work with a registered broker-dealer or registered investment advisor to invest in one. And when combining a DST with a 1031 exchange, you still need to follow the 1031 exchange rules, such as working with a qualified intermediary and following the timeline for identifying and closing on the replacement.
Invest eligible gains in a Qualified Opportunity Fund
You may instead elect to reinvest eligible gains in a Qualified Opportunity Fund. Such an investment might allow you to defer taxation on some of the capital gain you realize from the sale of real estate.
This approach differs from a 1031 exchange. A 1031 exchange requires you to exchange one real estate investment for another. In many cases, this means reinvesting the full sale proceeds into the replacement property to fully defer the gain. A Qualified Opportunity Fund investment requires that you reinvest eligible gains in a fund that invests in Qualified Opportunity Zone property. In other words, with a Qualified Opportunity Fund, you may only need to reinvest the eligible capital gain, not the entire amount you receive from the sale.
For example, say you sell a property for $1,000,000 and your adjusted basis in the property is $700,000. In that case, your gain is $300,000. With a 1031 exchange, you may need to reinvest the full sale proceeds to fully defer the gain. With a Qualified Opportunity Fund, you may only need to reinvest the $300,000 eligible gain to defer tax on that gain.
For certain individuals, a Qualified Opportunity Fund investment might make sense. For example, if you wish to defer at least some of the capital gain taxes generated by your sale of real estate, but do not want to purchase and take on the management of another property, then a Qualified Opportunity Fund might help you achieve your goals. It can also give you more flexibility because you do not necessarily need to reinvest the full proceeds from the sale.
You also do not have to invest the entire capital gain into the Qualified Opportunity Fund. For example, if your gain is $300,000 and you only want to invest $200,000, you may be able to do that. You would still pay tax on the portion of the gain that you did not invest, but you may still be able to defer tax on the portion you did invest.
One downside is that the capital gain deferral period for a Qualified Opportunity Fund may be shorter than the deferral period available through a 1031 exchange. For someone looking for longer-term deferral, this is an important difference to consider.
Note, though, that there are many rules and guidance surrounding the use of Qualified Opportunity Funds that must be followed. There are also strict deadlines for when funds must be invested, limits on which gains are eligible, and ongoing reporting requirements. As a result, you will want to consult with your tax advisor before choosing to use this strategy.
Maintain accurate records to prevent unnecessary recapture
When you replace a major building component, such as a roof or HVAC system, be sure to write off the undepreciated value of the old component. This prevents you from continuing to depreciate an asset that is no longer part of the property and having additional recapture when you sell the property.
It’s also crucial to treat true repairs as expenses rather than capital assets. If you could have expensed a repair but instead capitalized it, you’ve unintentionally created additional depreciation and additional recapture at sale.
Offset with passive losses
Suspended passive losses are common with rental properties due to depreciation. When you sell a property, you unlock these passive losses and can use them to offset some or all of your taxable gain upon sale, including depreciation recapture.
Pass the property to your heirs at death
If you don’t need to sell the property, you can hold on to it and pass it to your heirs. Appreciated property included in your estate receives a step-up in basis to fair market value at death. This eliminates capital gains and depreciation recapture.
Plan ahead to protect the wealth you’ve built
Each of these strategies has unique rules and risks, and may not be the right fit for your situation. That’s why it’s essential to discuss the decision with a tax advisor who can help you consider the implications and evaluate strategies to reduce or defer the tax hit.
Despite the eventual tax implications, depreciation is a valuable benefit of owning real estate. It reduces your taxable income, often during some of your highest-earning years. Depreciation doesn’t negate those benefits. In fact, in most cases, the tax savings realized during ownership far outweigh the depreciation recapture tax liability at sale, especially if you plan ahead to optimize the outcome.
By understanding how depreciation recapture works, you can make informed decisions about the timing and structure of the sale. If you’d like personalized guidance tailored to your situation, schedule a free tax discovery session. We’d be happy to help you evaluate your options and identify tax-efficient strategies to reduce your capital gains tax and keep more of your profits.