What about depreciation recapture in an exchange?

If you were to sell a depreciated property, the depreciation recapture would be subject to a 25% Federal tax. If the property is exchanged, that gain is rolled over into the replacement property with no tax currently due. If the replacement property is later sold in a cash-out transaction, the tax on the depreciation recapture will then be due.

Contrary to popular belief, that doesn’t mean the capital gains tax is inevitable eventually.  In a strategy that is called “swap ‘til you drop,” gains can be deferred for your entire lifetime. When you pass away, the property receives a new stepped up tax cost basis for your heirs, effectively wiping out the capital gains (including all depreciation recapture) that accrued during your lifetime. This is a strategy that should definitely be reviewed with your own tax advisor. If your net estate is above the tax-free level ($2,000,000 per person for 2007), there may be some potential tax savings in recognizing some capital gains.

All depreciation has always had to be essentially recaptured because it reduces your book value cost basis and thus increases your profit.  To not do so would give you a double deduction for the property cost.

The confusion many people have with this issue deals with the tax rate on the recapture.  For a long time, the recapture of normal straight line depreciation was at the lower long term capital gain rate.  However, when accelerated depreciation had been used, the excess over what the straight line deduction would have been was subject to ordinary income tax rates.

Currently, excess depreciation is subject to ordinary tax rates, while the straight line portion is subject to a 25% Federal rate.  Any additional gain (real appreciation) has a 15% maximum Federal tax rate.