As a rental property investor, you’re always looking for ways to maximize profits and minimize taxes. Depreciation is one of the biggest tax breaks available, allowing you to deduct the cost of the property’s structure over time. So, why would any savvy investor skip it?
Sometimes, investors mistakenly believe that avoiding annual depreciation deductions will help them escape the dreaded “depreciation recapture tax” when they sell. Unfortunately, this common misconception is a costly mistake.
Here’s the plain truth about not claiming rental property depreciation and the huge negative impact it has when you finally sell your investment.
The IRS Rule: Allowed or Allowable
The core of this issue lies in a fundamental IRS rule: when you sell a depreciable asset, you must calculate your profit (gain) based on the depreciation that was either “allowed” (the amount you actually claimed) or “allowable” (the amount you were legally entitled to claim).
The IRS doesn’t care if you actually took the deduction. You are required to reduce your property’s cost basis by the amount of depreciation you should have claimed.
Adjusted Basis=Original Cost+Improvements−Depreciation Allowed or Allowable
The Costly Consequence: A Higher Tax Bill 💰
By willfully choosing not to claim depreciation each year, you essentially subject yourself to the worst of both worlds:
1. You Missed Out on Annual Tax Savings
Depreciation is a non-cash deduction that reduces your taxable rental income every single year. By not taking it, you paid more in income tax annually than was necessary. This money could have been reinvested or saved.
2. Your Capital Gain is Still Inflated
When you sell the property for a profit, your capital gain is calculated using the lowered adjusted basis (reduced by the “allowable” depreciation).
- If your original cost basis was $300,000, and the total allowable depreciation over ten years was $80,000.
- Your adjusted basis at sale is $220,000 (even though you never claimed the $80,000 deduction).
If you sell the property for $450,000, your taxable gain is $230,000 ($450,000−$220,000). If you hadn’t had to reduce your basis, your gain would only have been $150,000. The missed deduction effectively becomes taxable gain.
3. You Pay the Depreciation Recapture Tax Anyway
Depreciation recapture is a tax on the portion of your gain equal to the depreciation that was allowed or allowable. For rental real estate (Section 1250 property), this portion of the gain is taxed at a maximum federal rate of 25%—a special rate higher than most long-term capital gains rates for middle-income earners.
Since your basis was reduced by the depreciation you should have taken, you created a gain subject to this recapture tax, yet you received no corresponding annual tax benefit!
| Scenario | Annual Tax Benefit (Missed) | Tax Recapture at Sale (Incurred) |
| Not Claiming Depreciation | $0 | Yes (on the “allowable” amount) |
| Claiming Depreciation | Yes (Annual Tax Savings) | Yes (on the “allowed” amount) |
What Can You Do to Fix Unclaimed Depreciation? 🛠️
If you realize you have failed to claim depreciation on your investment property, don’t panic! The IRS provides a mechanism to correct this, but you need to act fast and correctly.
- Consult a Tax Professional: This is not a task for DIY tax software. You need a CPA specializing in real estate taxation.
- File Form 3115: The most common way to fix a failure to claim depreciation is to file IRS Form 3115, Application for Change in Accounting Method. This allows you to take all of the depreciation you missed in prior years as a single lump-sum deduction in the current tax year. This recaptures the full annual benefit you lost!
- Amend Returns: For the most recent years (typically the last three), you might be able to file amended returns (Form 1040-X) to claim the deductions, though filing a Form 3115 is generally the cleaner, more comprehensive solution.
The Takeaway for Rental Property Investors
Depreciation is an essential part of maximizing your ROI on a rental property sale. The rule is clear: you must account for the reduction in basis due to allowable depreciation, whether you claimed it or not.
Don’t let a fear of depreciation recapture keep you from taking valuable, legal tax deductions today. Work with a tax expert to properly calculate and claim your depreciation. The alternative is paying more tax now and a much larger tax bill later. Your investment property deserves better planning!
