Depreciation Recapture (Section 1250)

Depreciation recapture under Section 1250 requires that part of the gain on sale of commercial real estate attributable to depreciation deductions be taxed at higher ordinary income rates or at a special recapture rate, rather than the lower long-term capital gains rate. For CRE owners, recapture increases the tax cost of selling property that benefited from prior depreciation, especially when accelerated methods were used. Lenders and borrowers must account for recapture when projecting net sale proceeds because it reduces cash available to repay debt or distribute to investors at disposition.

In underwriting sale or refinance scenarios, sponsors and lenders include Section 1250 recapture estimates to determine realistic after-tax proceeds and equity returns. Accurate recapture modeling requires tracking cumulative depreciation taken, the method used, and any applicable exceptions or limitations. This impacts pricing of acquisition offers, hold-versus-sell decisions, and the structuring of exits such as 1031 exchanges or deferred sales. For lenders, understanding recapture risk helps anticipate borrower liquidity needs and the sufficiency of proceeds to satisfy loan payoffs under various market conditions.

Depreciation recapture is important because it can significantly increase the tax bill at disposition and materially reduce the net proceeds available for debt repayment or investor distribution. Recapture can change the economic attractiveness of a sale versus exchange or continued ownership and influences the timing of exits. For lenders, recapture affects borrower cash flow planning and the realistic amount of equity returned on sale, which in turn informs pricing, covenant settings, and risk assessments. Ignoring recapture risks leads to overstated after-tax returns and potential shortfalls at payoff.