How Depreciation Recapture Works

Every year you own a rental property, the IRS requires you to depreciate the building portion of your cost basis. Residential rentals get depreciated over 27.5 years; commercial properties over 39 years. Those deductions offset your rental income and reduce your tax bill while you hold the property.

When you sell, the accumulated depreciation gets “recaptured” — meaning it’s taxed as income. The IRS applies this recapture whether or not you actually claimed the deductions. Their calculation is based on depreciation you were “allowed or allowable” to take, so skipping depreciation on your returns doesn’t help you avoid recapture at sale.

For LA landlords who’ve held property for 15 or 20 years, the depreciation total is substantial. A building with a $1.5 million depreciable basis generates roughly $54,545 per year in depreciation over 27.5 years. Hold it for 15 years and you’ve accumulated over $818,000 in depreciation — all of which faces recapture when you sell.

Federal Rate: 25% Under Section 1250

The federal tax on unrecaptured Section 1250 gain is capped at 25%. This rate is higher than the standard long-term capital gains rate (20% for high earners) but lower than the top ordinary income rate of 37%.

On top of the 25%, high-income sellers owe the 3.8% net investment income tax (NIIT) under Section 1411. This applies to the recapture gain, capital gain, and any other net investment income once your modified adjusted gross income exceeds $200,000 ($250,000 married filing jointly). For most LA property sellers, the NIIT is unavoidable.

So the effective federal rate on depreciation recapture for a high-income Los Angeles investor is 28.8% (25% + 3.8%).

California Taxes Recapture at Ordinary Income Rates

California does not distinguish between capital gains and ordinary income for state tax purposes. All income — wages, business income, capital gains, and depreciation recapture — is taxed at the same rates. The top California marginal rate is 13.3% on income above $1 million (the rate at $677,275+ is 12.3%, plus the 1% mental health services tax above $1 million).

This means a Los Angeles seller who recaptures $600,000 in depreciation pays up to $79,800 in California state tax on the recapture alone. Combined with $150,000 in federal recapture tax and $22,800 in NIIT, that’s over $252,000 in taxes on just the depreciation portion — before touching the capital gains tax on the rest of the profit.

California also doesn’t conform to the federal installment sale rules in all cases, and it doesn’t allow 1031 exchange deferral to reduce California taxable income if the replacement property is outside the state. If you sell LA property and do a 1031 exchange into a property in Texas, California will still want its tax when the replacement property is eventually sold.

A Real Example: Selling a Duplex in Echo Park

Suppose you bought a duplex in Echo Park in 2010 for $750,000 (building value $600,000, land $150,000). You’ve claimed $327,273 in depreciation over 15 years. The property is now worth $1.8 million.

Your adjusted basis: $750,000 minus $327,273 = $422,727. Total gain on sale: $1,377,273. Of that, $327,273 is depreciation recapture and $1,050,000 is long-term capital gain.

• Federal recapture tax (25%): $81,818
• Federal capital gains tax (20%): $210,000
• NIIT (3.8% on full gain): $52,336
• California state tax (13.3% on full gain): $183,178

Total tax: approximately $527,332. That’s 38.3% of the total gain. Over a quarter of the sale price goes to taxes. The recapture portion alone costs you roughly $125,000 in combined federal and state tax.

Deferral and Reduction Strategies

• 1031 like-kind exchange — the most common deferral strategy. Swap into a replacement property of equal or greater value and defer both capital gains and depreciation recapture. The catch for California: if the replacement property is out of state, California tracks the deferred gain with Form FTB 3840 and collects when the replacement property is sold
• Delaware statutory trust (DST) investments — qualify as like-kind replacement property for 1031 exchanges, allowing passive investors to defer recapture without actively managing a new property
• Charitable remainder trusts — donate the property to a CRT, which sells it tax-free. You receive an income stream and an immediate charitable deduction. The recapture is eliminated entirely, though you give up the property
• Opportunity zone reinvestment — invest capital gains into a qualified opportunity zone fund within 180 days. Several areas in South LA, Boyle Heights, and the San Fernando Valley are designated zones
• Installment sales — spread the capital gain over the payment period. But remember: depreciation recapture is fully recognized in year one regardless of payment schedule

California’s Out-of-State 1031 Tracking Rule

This is the detail that surprises LA investors doing 1031 exchanges. If you sell California property and exchange into property in another state, California requires you to file Form FTB 3840 every year to report the deferred gain. When you eventually sell the replacement property (or fail to do another exchange), California collects its tax on the original deferred gain — including the recapture portion.

The only way to permanently escape California’s claim on that deferred gain is to exchange back into California property (and eventually die owning it, getting a stepped-up basis). Moving to a different state doesn’t eliminate the California filing obligation on the deferred gain from the original sale.