"Don't Claim Depreciation and You Won't Pay Recapture." This Is Wrong, and It Costs Real Money

I have lost count of the number of times I have heard this.

"Just don't claim depreciation. Then there's nothing to recapture when you sell."

It sounds logical. You cannot claw back a benefit somebody never took. It sits alongside the other things overseas buyers get told, which I have collected in what British investors get sold in the USA. I have heard it from people selling courses, from people making videos, and once from a tax preparer talking to a client.

It is wrong. Not a matter of opinion. Not a grey area. Not one of those things that depends on your case. The tax code says the opposite in plain words, and the IRS acts on it.

And it is expensive. On a modest rental property held for ten years, believing the dogma costs about $9,600 in tax you never needed to pay, and you pay the recapture anyway.

Foreign investors are the most likely to fall for it, for a reason I will come to, and it is not stupidity. It is a sensible chain of thought that leads you down the wrong path.

What the tax code actually says

The rule sits in Internal Revenue Code section 1016(a)(2), and the phrase to remember is "allowed or allowable."

Allowed means the depreciation you actually claimed on your returns. Allowable means the depreciation you were entitled to claim, whether you did or not.

Your basis is reduced by whichever is greater.

So if you owned a rental property for ten years and never claimed a penny of depreciation, the IRS still treats your basis as though you had.

On sale, you are taxed on the difference between the sale price and your basis. So if your basis is lower, your gain is bigger, and the portion attributable to that depreciation is taxed as unrecaptured section 1250 gain at up to 25%.

The IRS sets this out in Publication 544, which tells you plainly to subtract the depreciation you took or could have taken. Publication 946 covers the same ground under a heading that leaves no room at all for doubt: "Basis adjustment for depreciation allowed or allowable."

You give up the deduction while you own it, and you pay the tax anyway. One CPA firm I read describes it as the worst of both worlds, which is about right.

The one thing to remember: depreciation is not optional in the way people think. Claiming the deduction is technically your choice. Being taxed as though you claimed it is not.

Why so many people say the opposite

I want to be fair here, because the people repeating this are not all careless. There is a genuine reason the confusion exists, and it is that two different rules share almost the same name.

Section 1250 recapture treats part of your gain as ordinary income. But it only applies to what the code calls additional depreciation, meaning accelerated depreciation in excess of straight line. A rental home bought after 1986 is written off on a straight line basis, so there is no additional depreciation and this rule almost never applies.

Unrecaptured section 1250 gain is the one that actually applies. It is taxed at up to 25%, and it is based on depreciation allowed or allowable.

So somebody reads about the first rule, sees that it rarely bites, and concludes that depreciation recapture is largely avoidable. Then they apply it to the second rule, which is the one that turns up on their return.

One is a technicality that seldom applies. The other is a 25% tax that usually does. Getting them the wrong way round is easy, and once the idea is loose online it spreads.

That said, there are also likely a lot of people out there giving bad advice because they simply do not know what they are talking about. Especially in today's world of uber-confident gurus. Said with enough confidence, anything can sound like legitimate advice.

What the mistake costs

Take a simple example. A $150,000 rental property, held for ten years. Say about 80% of the price was the building, which is the depreciable part, and you have $120,000 of depreciable basis, giving you $43,636 of depreciation over the decade.

The mistake costs you $9,600. They gave up every dollar of deduction and paid exactly the same tax at the end.

You can see what recapture would cost on your own property using our FIRPTA and capital gains calculator, which estimates the depreciation whether or not you claimed it.

And note something in the first table. Even for the person who does it correctly, depreciation is roughly a wash on a straight ten year hold at that tax rate. The benefit is delay, not saving. You get money now and pay it back later. Worth having, but it is not free money, and anyone who says it is has skipped a step.

And think about this. If you claim the depreciation, that money sits with you, not the IRS. That will prove very handy when you have a big unexpected cost like a furnace replacement, a new roof, a vacancy, or a heavy turnover. Trust me, you will be glad of that cash when you need it, and in my experience you will need it at some point.

I have set that argument out in full, with a year by year table showing what the reserve actually covers and when, in should Canadians claim CCA on a US rental. The country differs. The logic does not.

Why foreign investors are the most exposed

Here is why I am writing this for my own audience rather than for Americans.

If you live outside the US, there is a line of thinking that leads you straight into this mistake, and every step in it is sensible.

It goes like this. Your home country taxes your worldwide income. So your US rental profit is taxed at home too. Your home country gives you credit for whatever you paid the IRS, and then collects the difference.

Which means that if depreciation reduces your US tax bill, your foreign tax credit shrinks, and your home country simply collects what America did not.

So the depreciation appears to save you nothing.

That thinking is right as far as it goes. I have written the full version of it for British investors in UK tax on US rental income, and the conclusion there is exactly that: for a UK resident, depreciation is worth close to nothing.

And then you reach the obvious next thought. If it saves me nothing, why claim it at all?

That is the trap, and it is a better one than the American version, because the thinking that gets you there is sound.

The UK case, where it looks like it does not matter

Let me run it for a British higher rate taxpayer on that same $150,000 house.

The annual position is a wash either way. The sale position is identical.

So on the face of it, it does not matter. Which is why the advice sounds harmless to a British buyer.

Three reasons to claim it anyway.

Your credit can be wasted. A foreign tax credit is capped at the tax your home country charges on that income. If you deliberately pay more US tax than you need to, and that pushes your US tax above your UK tax on that income in any year, the excess credit is lost. You have paid money for nothing.

Your gain is bigger regardless. The basis reduction happens whether you claim or not. So you have not protected your gain. You have only cut your deductions.

And you have taken a filing position the IRS does not accept. Not claiming depreciation on a rental is not a neutral choice on a US return. It is a position, and their own guidance says otherwise.

My own case, where it matters a great deal

I live in Brazil. So the calculation looks completely different for me, and it is worth showing, because the same rule gives opposite results depending on where the owner lives.

I have no home country bill for the depreciation to run into. So my $0 US tax bill really is $0, and the deduction is worth the full $9,600 over that decade.

If I had skipped it, I would have handed over $9,600 of real money and still paid the $10,909 recapture at the end.

Same house. Same rule. Same country. Completely different value, purely because of where I live.

Which is the point I keep making about American property generally. The US half of the arithmetic is the same for everybody. What changes everything is the tax system where you sit when the rent arrives, and I have set both sides out in the US tax guide for foreign property investors.

How to fix it if you have already missed it

If you have owned a rental for years without claiming depreciation, do not panic and do not start amending returns.

Amending only reaches back two or three years, which usually misses most of it, and does nothing for the years before that.

The remedy is Form 3115, an application for a change in accounting method, with what is called a section 481(a) adjustment. It lets you catch up all the missed depreciation this year in one filing, however far back it goes.

Somebody who has owned a rental for a decade without claiming a penny can recover the entire amount this way.

This is not a form to attempt yourself. It is a specialist job and it needs a CPA who has done it before.

The bottom line

The advice is everywhere and it is wrong. You cannot avoid depreciation recapture by declining to claim depreciation. The code taxes you on what you were allowed to take, and your basis falls whether you file for it or not.

For an American, believing it costs you the deductions and changes nothing else. For a foreign investor it can look genuinely harmless, because your home country may be collecting the benefit anyway. It still is not, and the reasons are above.

Claim the depreciation. Every year. Whoever you are and wherever you live.

And if somebody is telling you otherwise on a video, ask them which code section they are relying on. The answer is section 1016(a)(2), and it does not say what they think it says.

Remember, investing is a game of probabilities. Tax law is not. It is written down, and you can go and read it.

If you want help working out what a specific property returns after tax on both sides, the free tools in my investor starter kit will get you started, and there is a full worked example across a ten year hold in selling a US rental as a UK resident.