Depreciation recapture

This page defines one term. If you have arrived here from a listing or a broker's summary, the useful order is: read what it is, then read what it does not tell you, and only then look at the number you were quoted. What would mislead: any single measure on a property is a summary of one year, one assumption or one document. None of them describes a whole investment, and the misreading section below is there because each of these terms has one that is extremely common.

The line above is the formula, written the way it is calculated. Every letter in it is an input somebody chose, which is why the same building can be quoted two different ways honestly. Where a number in the formula is an estimate — future rent, future expenses, a future sale price — the answer inherits the estimate.

The list below is how a whole deal is worked out, from the rent on the schedule to the cash an owner keeps. Find the step this term belongs to and you can see what it has already counted and what it has not. What would mislead: quoting one line of this sequence as though it were the answer. Each step subtracts something real, and the ones after it subtract more.

1. Rent roll Contract rent, tenant by tenant Start from the leases, not from a summary. Each line has a start date, an expiry, an escalation schedule, options, and any free rent or unamortised concession still running. The rent roll is a legal document set, and the estoppel certificates are how a buyer confirms the tenants agree with it.
2. Potential gross income Contract rent + market rent on vacant space + other income + expense recoveries What the property would produce fully leased, including parking, signage, storage, late fees and the reimbursements tenants owe for taxes, insurance and common-area costs. Recoveries are income and the matching expense is an expense — netting them hides the recovery ratio.
3. Effective gross income Potential gross income − vacancy − credit loss − concessions Deduct what will not actually be collected: physical vacancy, tenants who do not pay, and concessions granted. Using an assumed market vacancy rather than the property's own history is one of the most common places a model becomes optimistic.
4. Operating expenses Taxes + insurance + utilities + repairs + management + admin + payroll The cost of running the building for a year. Two lines deserve independent verification rather than acceptance: property taxes, which are frequently reassessed on a sale, and insurance, which is quoted to the buyer and not inherited from the seller. A market management fee belongs here even if the current owner charges none.
5. Net operating income Effective gross income − Operating expenses = NOI The property's own income, before financing and before tax. This is the number that value, cap rate and every lender covenant are calculated from, which is exactly why it is the number most often presented flatteringly.
6. Value and cap rate Value = NOI ÷ Cap rate · Cap rate = NOI ÷ Price One equation used in both directions. Divide NOI by a cap rate to estimate value; divide NOI by a price to see what a deal is being priced at. Because value is derived from NOI, every dollar added to or removed from NOI moves the value by a multiple of itself.
7. Capital items below the line NOI − capital expenditure − tenant improvements − leasing commissions Excluded from NOI by convention, but paid in cash. Roofs, parking lots, HVAC replacement, fitting out space for a new tenant and the commission that won the lease all come out of the same account. A reserve for them is the difference between an honest analysis and a brochure.
8. Debt service Cash flow before tax = NOI − annual debt service (− capital items) Interest and principal on the loan. This is where DSCR is tested, where the loan constant decides whether leverage is adding to or subtracting from cash flow, and where a covenant breach can divert income into a lender-controlled account before the owner sees it.
9. After tax Taxable income = NOI − interest − depreciation ± other adjustments Cash flow and taxable income are different numbers. Depreciation is deducted though no cash left, principal repayment is cash out though it is not deductible, and the resulting loss may be suspended under the passive activity rules rather than used. At sale, recapture and gain settle the difference.

• IRS Publication 544 — Sales and Other Dispositions of Assets ↗

This section is a structural reference, not investment, tax or legal advice, and nothing in it recommends buying, selling or financing any property. It contains no market quotes: no current cap rates, rents or prices, because those are negotiated privately and are not publicly quotable. Tax rules described here are general US federal mechanisms that change with legislation, and state and local rules differ. Verify anything that matters with an attorney, an accountant and an appraiser who know the specific property and jurisdiction.