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 IRSto 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% for 2022.
- 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 forwhich 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 IRSto 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, ifbusiness equipment was purchased for $10,000and had a depreciation expense of $2,000 per year, its adjusted cost basis after four yearswouldbe $10,000 - ($2,000 x 4) = $2,000.
For income tax purposes, the depreciation wouldbe recaptured if the equipment is sold for a gain. If the equipment is sold for $3,000, the business wouldhave 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 because the taxpayer has benefited from lower ordinary income over the previous years due to annual depreciation expense.
The realized gain from an asset sale must be compared with the accumulated depreciation. The smallerof 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 theunrecaptured gains section 1250 tax rate specific only to gains on real estate property. The unrecaptured section 1250 tax rate is capped at 25% for 2022.
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 for 2022. Unrecaptured section 1250 gains are limited to 25% for 2022. 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.
FAQs
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.
How is recapture depreciation calculated? ›
Calculating Depreciation Recapture
To determine the depreciation recapture, subtract the adjusted cost basis from the sale price for the asset.
What is an example of depreciation recapture? ›
Examples of Depreciation Recapture
The adjusted cost basis will be $1,000,000 – ($5,000 * 5) = $975,000. The gain from the sale will be the adjusted cost basis subtracted from the sale price: $990,000 – $975,000 = $15,000. As a result, when filing taxes, the property owner will need to file $15,000 in ordinary income.
Is depreciation recapture always at 25%? ›
Depreciation recapture is generally taxed as ordinary income up to a maximum rate of 25%.
How much depreciation do you recapture? ›
Depreciation expense can provide for some great tax savings while owning an investment property. Those savings may be too good to be true, and the IRS agrees. That's why they claw back 25% of depreciation expenses through depreciation recapture.
How to calculate depreciation on rental property when selling? ›
To calculate depreciation, all you have to do is divide the value of the property by its useful life (27.5 years for residential rental properties). The resulting amount can then be subtracted from the net income that the property generates.
What is depreciation recapture tax rate of 25%? ›
Depreciation Recapture Tax is one of the highest tax rates associated with the sale of real estate, a depreciable asset. Depreciation Recapture tax is 25% across the board, only second to real estate owned less than one year, taxed as ordinary income which could be as high as 37%.
How do you calculate recapture? ›
Start with your UCC in any class and add the amount you spent on new property in the class. Then, subtract the proceeds you earned from the disposition of property in that class.
How does IRS recapture depreciation? ›
Depreciation expense taken by a real estate investor is recaptured when the property is sold. Depreciation recapture is taxed at an investor's ordinary income tax rate, up to a maximum of 25%. Remaining profits from the sale of a rental property are taxed at the capital gains tax rate of 0%, 15%, or 20%.
How do you avoid depreciation recapture on rental property? ›
Use a 1031 Exchange
This is known as a 1031 exchange. So, if you sell your rental property, then turn around and use the funds to purchase another property worth a similar amount, you don't have to pay depreciation recapture or capital gains tax.
So part of the gain beyond the original cost basis would be taxed as a capital gain but the part that relates to depreciation is taxed at the 1250 rule rate. The unrecaptured section 1250 rate is capped at 25% for 2023.
What happens when you sell a fully depreciated property? ›
When selling the property, however, the depreciation that has been taken must be recaptured and paid back to the government. This is because depreciation is considered to be a form of deferred income, and when the property is sold, the deferred income becomes taxable.
What happens when you sell a fully depreciated asset? ›
When the fully depreciated asset is eventually disposed of, the accumulated depreciation account is debited and the asset account is credited in the amount of its original cost.
Does everyone pay depreciation recapture? ›
Internal Revenue Code Section 1250 states that depreciation must be recaptured if depreciation was allowed or allowable. So, even if you don't claim the annual depreciation expense on rental property that you're legally entitled to, you'll still have to pay tax on the gain due to depreciation when you decide to sell.
When you sell a rental property do you have to pay back depreciation? ›
When you sell your rental property, you'll need to pay tax on depreciation recapture and any remaining capital gains.
What happens if you never took depreciation on a property and then sold it? ›
IRS Code Section 1250 states that depreciation must be recaptured if it is allowable for the property. So, even if you don't claim depreciation for the years you owned the property, you'll still have to pay tax on the gain when you decide to sell.
How do you avoid depreciation recapture? ›
Exchange to avoid recapture
Another way to avoid depreciation recapture is by selling the property for less than its book value, which wouldn't make much sense. Another solution is to hold onto the asset until you die.
How to calculate the capital gains of a rental property when it is sold? ›
To calculate your gain, subtract the adjusted basis of your property at the time of sale from the sales price your rental property sold for, including sales expenses such as legal fees and sales commissions paid.
How does IRS calculate depreciation on rental property? ›
Depreciation commences as soon as the property is placed in service or available to use as a rental. By convention, most U.S. residential rental property is depreciated at a rate of 3.636% each year for 27.5 years. Only the value of buildings can be depreciated; you cannot depreciate land.
What triggers depreciation recapture? ›
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.
If you swap one investment property for another and roll the entirety of sales proceeds into the new asset, you can defer both depreciation recapture and capital gains taxes. If you divest the replacement asset, though, you'll have to pay the accumulated depreciation recapture and capital gains taxes.
What percent is recapture tax? ›
Key Takeaways
Depreciation recapture is the IRS' way of recouping taxes from deductions you made for the depreciation of an asset that you sell. Depreciation recapture can have a big impact on the sale of residential real estate property. Generally speaking, the depreciation recapture tax rate is 25%.
What is an example of a recapture? ›
For example, say a business equipment was purchased for $10,000, and had a depreciation cost of $2,000 per year. After four years, its adjusted cost basis will be $10,000 – ($2,000 x 4) = $2,000. The depreciation will be recaptured if the equipment is sold for a gain.
How to calculate 1250 depreciation recapture? ›
How Do I Calculate Section 1250 Recapture? Section 1250 is calculated as the lesser of two amounts. The first amount is the excess of accelerated depreciation claimed on real property over what would have been the allowable amount under a straight-line method. The second amount is the gain realized upon disposition.
What is the rule of recapture? ›
The Alimony Recapture Rule, an infrequently-discussed tax trap, is an unpleasant surprise for some divorced individuals ordered to make alimony payments to their former spouse. In short, alimony recapture operates to force the alimony payer to report alimony payments they previously deducted to the IRS as income.
What happens if you take too much depreciation on rental property? ›
If you took too much depreciation, you must decrease your basis by the amount you should have deducted, plus the part of the excess you deducted that actually lowered your tax liability for any year.
How do I claim catch up depreciation on my rental property? ›
To claim rental property depreciation, you'll file IRS Form 4562 to get your deduction. Review the instructions for Form 4562 if you're filing your tax return on your own or consult a qualified financial advisor or tax accountant for assistance.
Can you write off depreciation on a rental property? ›
If you receive rental income from the rental of a dwelling unit, there are certain rental expenses you may deduct on your tax return. These expenses may include mortgage interest, property tax, operating expenses, depreciation, and repairs.
Does depreciation recapture ever go away? ›
If the realized gain ends up being negative (a realized loss), there is no depreciation recapture as you sold the item for a loss and will not need to pay income or capital gains taxes.
What are the new depreciation rules for 2023? ›
The rules allow Bonus Depreciation to 100% for all qualified purchases made between September 27, 2017 and January 1, 2023. Bonus Depreciation now ramps down to 80%, starting in 2023. Bonus depreciation will continue to ramp down for ensuing years: 60% for 2024, 40% for 2025, 20% for 2026, and 0% beginning in 2027.
If the asset is still used in the company's operations, the asset's account and accumulated depreciation will still be reported on the company's balance sheet. The reported asset's value and accumulated depreciation will be equal, but no entry will be required until the asset is disposed of.
How do you write off a fully depreciated asset? ›
Fully depreciated asset: With zero proceeds from the disposal, debit accumulated depreciation and credit the fixed asset account. Gain on asset sale: Debit cash for the amount received, debit all accumulated depreciation, credit the fixed asset, and credit the gain on sale of the asset account.
What assets are subject to depreciation recapture? ›
Depreciation recapture applies to any asset that was depreciated on your tax returns. Income-producing real estate and business equipment are two commonly depreciated items, but depreciation can be claimed on a wide range of tangible capital assets, including: Vehicles used for business purposes. Machinery and ...
How do you calculate depreciation when selling an asset? ›
Subtract the asset's salvage value from its cost to determine the amount that can be depreciated. Divide this amount by the number of years in the asset's useful lifespan. Divide by 12 to tell you the monthly depreciation for the asset.
Is recapture 100% taxable? ›
Through a process known as depreciation recapture, the IRS assesses a flat tax of 25% on a property's total eligible straight-line depreciation during the ownership period. That is, even if you don't claim depreciation, the IRS will still assess the depreciation recapture tax when you sell a property.
What is the downside of depreciation rental property? ›
The Downside: Depreciation Recapture
The IRS considers depreciation an actual decrease in the rental property's value. This means that, in the eyes of the IRS, the property will be deemed to have a lower adjusted value when sold. All depreciated value will be subtracted from the purchase price for this adjustment.
What if I did not deduct depreciation on rental property? ›
What happens if you don't depreciate rental property? In essence, you lose the opportunity to claim a massive tax benefit. If/when you decide to sell the property, you will still pay depreciation recapture tax, regardless of whether or not you claimed the depreciation during your tenure as the owner of the property.
Is selling a rental property a capital gain or ordinary income? ›
Capital Gains Tax on Selling a Rental Home
If you hold rental property, the gain or loss when you sell is generally characterized as a capital gain or loss. If held for more than one year, it's long-term capital gain or loss, and if held for one year or less, it's short-term capital gain or loss.
What is the best depreciation method for rental property? ›
While there are many different types of depreciation that can be applied to an asset like a residential rental property, straight-line depreciation has become the most common for American real estate investors, with the IRS having standardized depreciation under this method.
Is there any way to avoid depreciation recapture? ›
One of the best ways is to use a 1031 exchange, which references Section 1031 of the IRS tax code. This may help you avoid depreciation recapture and any capital gains taxes that might apply.
Depreciation recapture applies to any asset that was depreciated on your tax returns. Income-producing real estate and business equipment are two commonly depreciated items, but depreciation can be claimed on a wide range of tangible capital assets, including: Vehicles used for business purposes. Machinery and ...
How does recapture work? ›
Recapture allows a seller of some asset or property to reclaim some or all of it at a later date. The seller will have the option to buy back what has been sold, within a certain window of time, often at a higher price than what it was initially sold for.
