If you’re a real estate investor, you’ve probably heard this warning more times than you can count:

“If you depreciate a property, you’re just going to have to pay it all back when you sell.”

That belief shows up every tax season. It scares property owners away from powerful tax deductions. And worse, it causes investors who did use cost segregation and bonus depreciation to overpay depreciation recapture tax when they sell an investment property.

The issue isn’t depreciation deducting.

The issue is what happens after—when investors don’t understand how recapture really works.

Watch my in-depth discussion on depreciation recapture with Chris Streit here. 

Should Real Estate Investors Be Afraid Of Depreciation Recapture?

I don’t believe fear belongs anywhere in tax planning.

Depreciation is one of the most powerful tools available to real estate investors because it reduces tax liability without reducing cash flow. On your tax returns, it shows up as a paper expense—but it can dramatically lower your income tax rate in the early years of ownership.

When used correctly, depreciation isn’t a loophole. It’s a tax benefit and timing tool.

The mistake happens when investors assume that every dollar of depreciation automatically comes back at sale, dollar for dollar, at the worst possible rate. That assumption leads to bad decisions—either skipping cost segregation altogether or blindly accepting inflated tax bills later.

What Is Cost Segregation Really Doing?

When you buy rental property or any income-producing investment property, the IRS assigns it a depreciation schedule:

• 27.5 years for residential rental property
  
• 39 years for commercial real estate
  

Cost segregation changes how that depreciation is applied.

Instead of treating the entire building as one asset, cost segregation breaks it into components with shorter lives—things like flooring, cabinets, lighting, wiring, appliances, and certain land improvements.

Many of those components qualify as personal property, not real property. That distinction matters because it allows faster depreciation schedules and, in many cases, bonus depreciation.

After the Tax Cuts and Jobs Act expanded bonus depreciation, cost segregation became a go-to strategy for real estate investments because it created larger tax deductions earlier and reduced near-term tax bills.

But that front-end benefit only works if you plan for the back end.

Request a FREE Cost Segregation Benefit Analysis

What Does Depreciation Recapture Mean When You Sell?

Depreciation recapture is simply the IRS reconciling the tax deductions you took while owning the property with the gain you recognize when you sell it.

If you depreciate an asset and later sell it, the IRS wants to know what portion of your gain is tied to those deductions. That’s where recapture comes in.

In real estate, the type of property you depreciate determines how recapture works—and that’s where many investors stumble after using cost segregation.

Why Does §1245 Recapture Catch Investors Off Guard?

Most investors believe depreciation recapture is capped at a lower rate. That belief usually comes from experience with structural depreciation.

But when you accelerate depreciation through cost segregation, you often create section 1245 property. That category can be subject to recapture at ordinary income tax rates, not long-term capital gains rates.

That can be a big surprise for investors. An investor enjoys big tax deductions up front, sells five years later, and suddenly sees part of the gain taxed at their highest income tax rate. That’s why depreciation recapture tax feels so painful and can wipe out part of the benefit when you don’t handle it correctly.

What Is The §1245 Move Most Investors Skip?

Here’s the part almost no one talks about:

You only owe depreciation recapture based on what those assets are worth at the time of sale.

Most investors never question that value.

Think about it this way. Carpets, appliances, cabinets, and fixtures lose value fast. After five years, carpet holds far less value than it did when it was installed. The same holds true for microwaves, refrigerators, or land improvements.

Yet many property owners treat those assets as if they’re still brand new when calculating depreciation recapture. That single assumption inflates tax liability and leads to unnecessary tax bills.

How Do You Reduce §1245 Recapture At Sale?

A cost segregation study breaks the property into individual assets from the start. That gives you the opportunity to revalue those assets independently at sale.

By documenting the fair market value of personal property at the time of sale, you can reduce the portion of gain treated as section 1245 recapture. The remaining value is absorbed into the structural category.

The result is simple:

• Less gain taxed at ordinary income rates
  
• More gain taxed as long-term capital gain

That rate difference is where real savings show up on your tax return.

Why Does Substantiation Matter So Much?

The IRS allows this approach—but they don’t take your word for it.

To reduce depreciation recapture tax, you must substantiate the value of the assets. That means showing what those items are actually worth at sale, based on real-world data.

This is where many investors stop short. Without substantiation, the IRS defaults to assumptions. And assumptions almost always favor higher tax bills.

How Much Can This Actually Change The Bottom Line?

Let’s put this into perspective.

It’s common to see an investor take six figures of accelerated depreciation on a property. When investors sell the property a few years later, many assume the entire amount falls under section 1245 recapture.

When assets are properly revalued, that number can drop dramatically. Instead of recapturing the full accelerated amount, only the current value of those assets is recaptured. The rest shifts into long-term capital gain treatment.

That difference doesn’t eliminate tax—but it can significantly reduce tax liability and protect the bottom line.

What Does A “§1245 Exchange” Mean In Plain English?

You may hear this strategy referred to as a “§1245 exchange.”

In plain English, it means reallocating value based on reality. Assets that have worn out shouldn’t be taxed as if they’re new. By revaluing personal property at sale, more of the gain is treated like structural real property rather than accelerated personal property.

It’s not aggressive. It’s accurate.

Who Should Be Thinking About This Strategy?

This approach is most effective for:

• Real estate investors who used cost segregation
  
• Properties held roughly 2–8 years
  
• Deals with meaningful accelerated depreciation
  
• Short-term rentals and higher-basis single-family rentals
  
• Syndications that performed cost segregation

If the property was held for decades or depreciation was minimal, the benefit may be smaller. But for many investment properties, the opportunity is substantial.

Can This Be Done After A Property Is Sold?

In many cases, yes—if the sale occurred in the current tax year.

That’s important, because once tax returns are filed, options disappear. Reviewing depreciation recapture before the return is finalized is critical.

What Is The Biggest Mistake Investors Make With Recapture?

The biggest mistake isn’t using depreciation.

It’s accepting default assumptions.

Depreciation recapture tax isn’t something to fear—but it is something to plan for. When investors don’t plan, they often pay more than the tax laws require.

Ready To See How This Impacts Your Tax Return?

If you’re a real estate investor selling rental property, exiting an investment property, or preparing tax returns after using cost segregation for real estate investors, this is the moment to get clarity.

A free 45-minute Strategy Session with an Anderson Advisors Senior Advisor allows us to walk through your numbers and apply smart tax planning for real estate investors to your situation, including how to:

• Understand how depreciation schedules affect your overall tax liability
  
• Determine whether section 1245 applies to your sale
  
• Evaluate whether revaluing personal property could reduce depreciation recapture tax
  
• Align cost segregation for real estate investors with long-term real estate tax strategies
  
• Avoid unnecessary tax bills caused by default assumptions at filing
  

This isn’t about avoiding taxes. It’s about applying the tax code correctly—and protecting your bottom line.

Schedule your free Strategy Session before your return is filed and the outcome is permanent.