Depreciation Recapture Planning

Depreciation recapture is the portion of gain attributable to depreciation deductions previously claimed on the relinquished property, and it is taxed differently from the remaining capital gain, generally at a federal rate of up to twenty five percent for real property under Section 1250 rather than standard long-term capital gains rates. A properly structured 1031 exchange defers depreciation recapture along with the rest of the gain, but the two components remain distinct for tax reporting purposes.

A Los Angeles property held for many years, with substantial accumulated depreciation deductions taken against ordinary income during the holding period, carries a correspondingly larger recapture exposure if the exchange is not properly structured or if boot triggers partial gain recognition. We review the accumulated depreciation schedule on the relinquished property early so the exchanger understands the full stakes of a successful, fully deferred exchange.

When an exchange triggers boot, the recognized gain is generally treated as depreciation recapture first, up to the amount of accumulated depreciation, before any remaining recognized gain is treated as capital gain, which means even a modest amount of boot can carry a disproportionately higher tax rate than an equivalent amount of straight capital gain. We factor this ordering into boot minimization planning rather than treating all recognized gain as taxed uniformly.

Unlike the federal system, California taxes both capital gain and depreciation recapture as ordinary income under the state's personal income tax brackets, which can reach thirteen point three percent at the top bracket, so a Los Angeles exchanger who allows any gain to be recognized faces meaningfully higher effective state tax exposure than an investor in a state without an income tax.

Because a fully deferred exchange, with no boot and a replacement property equal to or greater than the relinquished property in both value and debt, defers the entire gain including the depreciation recapture component, the most reliable way to manage recapture exposure is generally to structure the exchange to avoid triggering any recognized gain at all rather than trying to plan around a partial recapture event.

We recommend reviewing the accumulated depreciation schedule on a Los Angeles relinquished property before it is even listed for sale, since understanding the full recapture exposure in advance shapes how aggressively an exchanger should prioritize a fully deferred exchange structure over accepting any boot.