Depreciation is one of the biggest reasons limited partners invest in real estate funds. It reduces taxable income, improves after-tax cash flow, and allows investors to defer taxes while capital compounds. But every experienced LP eventually hears the same question: What happens at exit?

That question leads directly to depreciation recapture—a concept that is often misunderstood, overstated, or framed as a downside that somehow “undoes” the benefits of depreciation. In reality, depreciation recapture is a predictable, manageable part of real estate investing, and when understood correctly, it does not negate the value of depreciation.

This article explains how depreciation recapture works in real estate funds, how it affects limited partners, and how sophisticated investors think about it.

What Depreciation Recapture Actually Is

Depreciation recapture is the IRS mechanism for taxing depreciation deductions when a property is sold. During ownership, depreciation reduces taxable income. When the asset is sold, the IRS “recaptures” some of those deductions by taxing a portion of the gain at a different rate.

For residential real estate, depreciation recapture is generally taxed at a maximum federal rate of 25%, separate from long-term capital gains. This applies only to the portion of gain attributable to depreciation taken—not to the entire profit.

The key point is this: recapture applies only because depreciation created tax benefits earlier. Without depreciation, there would be nothing to recapture.

How Depreciation Flows Through a Real Estate Fund

In a real estate fund, depreciation is calculated at the property level and allocated to investors through the partnership structure. Each LP receives their share of depreciation annually via Schedule K-1, reducing taxable income during the hold period.

When the fund sells the property, the cumulative depreciation taken over the life of the investment becomes relevant for tax reporting. The recapture calculation is also handled at the fund level and passed through to investors.

LPs do not calculate recapture individually. It is reflected in the final K-1 and related tax reporting for the year of sale.

Why Depreciation Recapture Is Often Overstated

Many investors incorrectly assume that depreciation recapture “gives back” all the tax benefits they received. That is not how it works.

First, recapture is taxed at a lower rate than ordinary income for most investors. Second, depreciation provided value years earlier, allowing investors to defer taxes and reinvest or earn returns on capital that would otherwise have gone to the IRS. Third, only the depreciation portion is subject to recapture—not the full gain.

When evaluated correctly, depreciation recapture represents tax deferral with time value, not a penalty.

The Time Value of Money Advantage

The most important concept for LPs to understand is the time value of money.

Receiving tax benefits today and paying some portion of them years later is economically favorable. A dollar saved today is worth more than a dollar paid in the future, especially when that capital is invested and compounding.

In real estate funds with five- to ten-year hold periods, depreciation allows LPs to keep more capital working for them during the most productive years of the investment.

How Cost Segregation Affects Recapture

Cost segregation accelerates depreciation into earlier years. This can increase the amount of depreciation subject to recapture later, but it also increases the magnitude and timing of tax deferral.

For LPs, this trade-off is usually favorable. Accelerated depreciation improves early-year cash efficiency and portfolio flexibility. Even with recapture at exit, the net present value of the tax benefit is often strongly positive.

Importantly, recapture rates do not increase simply because depreciation was accelerated. The rate applies to the depreciated amount regardless of timing.

Passive Activity Losses and Recapture

Many LPs cannot immediately use depreciation losses due to passive activity rules. These losses are suspended and carried forward.

When a property is sold, suspended passive losses are typically released and can be used to offset income in the year of sale—including gains and recapture. This often softens the tax impact at exit.

For LPs with accumulated suspended losses, depreciation recapture may be partially or fully offset, depending on individual circumstances.

Capital Gains vs Depreciation Recapture

At exit, total profit is generally split into two components for tax purposes: depreciation recapture and capital gains.

Depreciation recapture applies only to the portion of gain attributable to depreciation taken. Any remaining gain is typically taxed at long-term capital gains rates, which are often lower than ordinary income rates.

Understanding this distinction is critical. LPs are not taxed on all proceeds at recapture rates—only on the depreciated portion.

How 1031 Exchanges Change the Equation

In some cases, real estate funds may execute a 1031 exchange, rolling proceeds into a new property instead of selling outright. When structured properly, a 1031 exchange can defer both capital gains and depreciation recapture.

For LPs in long-term strategies or evergreen vehicles, exchanges allow depreciation benefits to continue compounding across multiple properties. Taxes are deferred, not eliminated, but the deferral period can span decades.

Why Sophisticated LPs Accept Depreciation Recapture

Experienced limited partners do not avoid depreciation because of recapture. They evaluate depreciation in terms of after-tax internal rate of return, not headline tax rates.

From that perspective, depreciation remains one of the most powerful advantages of real estate funds. Recapture is simply part of the lifecycle—planned for, modeled, and managed.

Avoiding depreciation to avoid recapture would be economically irrational, much like refusing deductions today because you might pay taxes later.

Questions LPs Should Ask Sponsors

LPs should understand how a sponsor approaches depreciation and exit planning. This includes whether cost segregation is used, how long the sponsor expects to hold assets, and whether exchanges are part of the strategy.

Sponsors who can clearly explain depreciation recapture demonstrate sophistication and transparency. Those who avoid the topic or oversimplify it may not fully understand the tax mechanics themselves.

Conclusion: Depreciation Recapture Is a Feature, Not a Flaw

Depreciation recapture is not a surprise, a loophole closure, or a hidden downside. It is the natural counterpart to one of real estate’s greatest tax advantages.

For limited partners, the correct way to think about depreciation recapture is not as a loss, but as the cost of having used tax-deferred capital productively for years. When viewed through that lens, depreciation remains a cornerstone of real estate fund investing—and recapture is simply part of doing the math honestly.