Depreciation recapture is the part of a real estate sale that surprises owners who focus only on the capital gains rate. Every year of depreciation deducted against rental or commercial property lowers the property's adjusted basis, and when the property is sold, the portion of gain attributable to that depreciation is generally taxed under Section 1250 rules at a rate that can run higher than the long-term capital gains rate applied to the rest of the gain. It does not go away by holding the property longer; it accumulates every year depreciation is claimed.
Two structures defer recapture along with the rest of the gain: a Section 1031 exchange into replacement real property, and a Section 721 contribution of the property to a REIT's operating partnership in exchange for OP units. Both avoid immediate recognition of the recapture amount, but they do it through different legal mechanisms, and they leave the owner in a different position afterward.
Understanding which structure actually defers recapture, and what happens to that deferred amount later, matters more than the headline capital gains number when an owner is deciding how to exit an older, heavily depreciated property.
When a depreciable property is sold, the IRS separates the total gain into a recapture portion, tied to depreciation deductions taken over the holding period, and the remaining capital gain, tied to appreciation in the property's value beyond its original cost. IRS Publication 544 walks through this allocation, and the calculation depends on the type of property and the depreciation method used, with residential and nonresidential real property generally treated under Section 1250 rather than the steeper Section 1245 rules that apply to certain personal property.
The longer a property has been held and depreciated, the larger the recapture component tends to be relative to total gain, which is why owners of properties held for fifteen or twenty years often find recapture drives a meaningful share of their total tax bill on sale, not just an afterthought behind the capital gains calculation.
A 1031 exchange defers recapture the same way it defers the rest of the gain: by rolling the adjusted basis of the relinquished property, including the depreciation already taken, into the replacement property rather than recognizing it at sale. The replacement property inherits a carryover basis, and the deferred recapture amount stays attached to that basis until the owner eventually sells without exchanging again.
The mechanics run through the identification and closing deadlines under 26 CFR 1.1031(k)-1, and the deferral is reported using IRS Form 8824. Depreciation resumes on the replacement property going forward, which means new depreciation deductions start accumulating on top of the deferred recapture already carried over, a detail that surprises owners expecting a clean reset.
A Section 721 contribution defers recapture through a different mechanism. Under 26 U.S.C. Section 721, no gain or loss is generally recognized when property is contributed to a partnership in exchange for a partnership interest, and that nonrecognition covers the recapture component along with the rest of the built-in gain. The property's basis, and the depreciation history behind it, carries into the operating partnership's books rather than into a new property the owner selects.
The distinction that matters here is what the owner now holds. After a 1031 exchange, the owner still owns real property and depreciation continues to run against a specific asset the owner can see and manage. After a 721 contribution, the owner holds OP units, and the deferred recapture becomes part of a partnership interest whose eventual sale, redemption, or conversion to REIT shares is what finally triggers recognition, not the sale of any particular building.
Deferred recapture inside a 1031 exchange is triggered by a future sale of the replacement property that is not itself run through another exchange. An owner who keeps exchanging can keep deferring recapture across multiple properties over decades, though each new property carries the accumulated deferred amount forward.
Deferred recapture inside OP units is triggered when the units are sold or redeemed for cash, or when they are converted to REIT shares and those shares are later sold. There is no equivalent to repeated exchanging once the property is inside the operating partnership; the deferral clock effectively runs until the unit holder takes one of those exit actions, which is a decision made at the unit level rather than the property level.
An owner whose recapture exposure is large relative to total gain has reason to weigh both the size of the deferral and what happens after it. A 1031 exchange keeps the recapture attached to real property the owner continues to manage, with recapture exposure growing again as new depreciation is claimed on the replacement asset. A 721 contribution moves that exposure into a partnership interest the owner does not manage directly, with recognition ultimately tied to a decision about the units rather than a property sale.
Neither path eliminates the recapture liability building up; both simply postpone the point at which it is recognized. The choice depends on whether the owner wants to keep depreciable real estate on the books, with its recurring recapture exposure, or move into OP units where the deferred amount rides along with a passive holding until it is eventually cashed out.