What Is Depreciation Recapture?
Depreciation recapture is the gain realized by the sale of depreciable capital property that must be reported as ordinary income for tax purposes. Depreciation recapture is assessed when the sale price of an asset exceeds the tax basis or adjusted cost basis. The difference between these figures is thus “recaptured” by reporting it as ordinary income.
Depreciation recapture is reported on Internal Revenue Service (IRS) Form 4797.
Key Takeaways
- Depreciation recapture is a tax provision that allows the IRS to collect taxes on any profitable sale of an asset that the taxpayer had used to previously offset taxable income.
- Depreciation recapture on non-real estate property is taxed at the taxpayer’s ordinary income tax rate, rather than the more favorable capital gains tax rate.
- Depreciation recaptures on gains specific to real estate property are capped at a maximum of 25%.
- To calculate the amount of depreciation recapture, the adjusted cost basis of the asset must be compared to the sale price of the asset.
Understanding Depreciation Recapture
Companies account for wear and tear on property, plant, and equipment through depreciation. Depreciation divides the cost associated with the use of an asset over a number of years. The IRS publishes specific depreciation schedules for different classes of assets. The schedules tell a taxpayer what percentage of an asset’s value may be deducted each year and the number of years for which the deductions may be taken.
For tax purposes, annual depreciation expense lowers the ordinary income that a company or individual pays each year and reduces the adjusted cost basis of the asset. If the depreciated asset is disposed of or sold for a gain, the ordinary income tax rate will be applied to the amount of the depreciation expense previously taken on the asset.
Depreciation recapture is a tax provision that allows the IRS to collect taxes on any profitable sale of an asset that the taxpayer had used to previously offset their taxable income. Since depreciation of an asset can be used to deduct ordinary income, any gain from the disposal of the asset must be reported and taxed as ordinary income, rather than the more favorable capital gains tax rate.
Depreciable capital assets held by a business for over a year are considered to be Section 1231 property, as defined in Section 1231 of the IRS Code. Section 1231 is an umbrella for both Section 1245 property and Section 1250 property. Section 1245 refers to capital property that is not a building or structural component. Section 1250 refers to real estate property, such as buildings and land. The tax rate for the depreciation recapture will depend on whether an asset is a section 1245 or 1250 asset.
Examples of Depreciation Recapture
Section 1245 Depreciation Recapture
The first step in evaluating depreciation recapture is to determine the cost basis of the asset. The original cost basis is the price that was paid to acquire the asset. The adjusted cost basis is the original cost basis minus any allowed or allowable depreciation expense incurred. For example, if business equipment was purchased for $10,000 and had a depreciation expense of $2,000 per year, its adjusted cost basis after four years would be $10,000 – ($2,000 x 4) = $2,000.
For income tax purposes, the depreciation would be recaptured if the equipment is sold for a gain. If the equipment is sold for $3,000, the business would have a taxable gain of $3,000 – $2,000 = $1,000. It is easy to think that a loss occurred from the sale since the asset was purchased for $10,000 and sold for only $3,000. However, gains and losses are realized from the adjusted cost basis, not the original cost basis. The reasoning for this method is that the taxpayer has benefited from lower ordinary income over the previous years due to annual depreciation expenses.
Gains and losses are realized from the adjusted cost basis, not the original cost basis.
The realized gain from an asset sale must be compared with the accumulated depreciation. The smaller of the two figures is considered to be the depreciation recapture. In our example above, since the realized gain on the sale of the equipment is $1,000, and accumulated depreciation taken through year four is $8,000, the depreciation recapture is thus $1,000. This recaptured amount will be treated as ordinary income when taxes are filed for the year.
Instead, assume the equipment in the example above was sold for $12,000. In that case, the entire accumulated depreciation of $8,000 is treated as ordinary income for depreciation recapture purposes. The additional $2,000 is treated as a capital gain, and it is taxed at the favorable capital gains rate. There is no depreciation to recapture if a loss was realized on the sale of a depreciated asset.
Unrecaptured Section 1250 Gain
Depreciation recapture on real estate property is not taxed at the ordinary income rate as long as straight-line depreciation was used over the life of the property. Any accelerated depreciation previously taken is still taxed at the ordinary income tax rate during recapture. However, this is a rare occurrence because the IRS has mandated all post-1986 real estate be depreciated using the straight-line method.
Part of the gain beyond the original cost basis is taxed as a capital gain and qualifies for the favorable tax rate on long-term gains, but the part that is related to depreciation is taxed at the unrecaptured gains section 1250 tax rate specific only to gains on real estate property. The unrecaptured section 1250 tax rate is currently capped at 25%.
For example, consider a rental property that was purchased for $275,000 and has an annual depreciation of $10,000 ($275,000 / 27.5 years allowed by IRS for rental property). After 11 years, the owner decides to sell the property for $430,000. The adjusted cost basis then is $275,000 – ($10,000 x 11) = $165,000. The realized gain on the sale will be $430,000 – $165,000 = $265,000. The unrecaptured section 1250 gain can be calculated as $10,000 x 11 = $110,000, and the capital gain on the property is $265,000 – ($10,000 x 11) = $155,000.
Let’s assume a 15% capital gains tax and that the owner falls in the 32% income tax bracket. Unrecaptured section 1250 gains are limited to 25%. The total amount of tax that the taxpayer will owe on the sale of this rental property is (0.15 x $155,000) + (0.25 x $110,000) = $23,250 + $27,500 = $50,750. The depreciation recapture amount is, thus, $27,500.
How Do You Calculate Depreciation Recapture?
Depreciation recapture is calculated by subtracting the adjusted cost basis from the sale price of the asset. The adjusted cost basis is the original price paid to acquire the asset minus any allowed or allowable depreciation expense incurred. If, for example, the adjusted cost basis is $2,000 and the asset is sold for $3,000, there is a gain of $1,000 to be taxed. The rate it will be taxed depends on the taxpayer’s income tax rate and whether the asset is real estate.
How Is Depreciation Recapture Treated?
Depreciation recapture is treated as ordinary income and taxed as such. With real estate, it’s a little more complicated. The gain beyond the original cost basis is taxed as a capital gain, whereas the part that is related to depreciation is taxed at the unrecaptured gains section 1250 tax rate, which is capped at 25%.
How Can I Avoid Depreciation Recapture?
Depreciation recapture can be quite costly when selling something like real estate. Other than selling the property for less, which isn’t a favorable option, ways around it could include using the IRS Section 121 exclusion or passing the property to your heirs. If you find yourself in this position, speak to an expert before acting.
The Bottom Line
Depreciation recapture offers the IRS a way to collect taxes on the profitable sale of an asset that a taxpayer used to offset taxable income. While owning the asset, the taxpayer is permitted each year to expense its declining value to reduce the amount of income tax owed. However, if that asset is later sold, the IRS may be able to claw some of that money back.
Depreciation recapture is calculated by subtracting the adjusted cost basis, which is the price paid for the asset minus any allowed or allowable depreciation expense incurred, from the sale price. It only applies when an asset is sold for more than its adjusted cost basis and is taxed differently depending on the type of asset. Depreciation recapture on non-real estate property is taxed at the taxpayer’s ordinary income tax rate. Depreciation recapture on gains specific to real estate property, on the other hand, is capped at a maximum of 25%.
