A procedure by the Internal Revenue Service (IRS) in the U.S. to collect taxes on the sale of depreciated property
Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets.
Written byCFI Team
Depreciation recapture is a procedure by the Internal Revenue Service (IRS) in the U.S. to collect taxes on the sale of property that’s been depreciated.
The property must have been previously used to offset the owner’s ordinary income due to depreciation. Therefore, when you file taxes, the gain from the sale of the property must be reported as ordinary income, not capital gain.
When an asset depreciates, it is when it loses value over time. The sale of a depreciated asset can be reported as ordinary income if the sale price is more than its adjusted cost basis. The difference between the figures must be reported as part of the individual’s ordinary income when they file their taxes.
What is Adjusted Cost Basis?
Adjusted Cost Basis = Asset’s Purchase Price + Improvements – Depreciation Deductions
According to IRC Section 1016, the adjusted cost basis is the net cost of an asset after adjusting for increases in improvements to the property or decreases in depreciation deductions allowed for the property.
Therefore, if the asset’s purchase price is $50,000, and there is $2,000 per year in depreciation deductions for the next four years, then the adjusted cost basis for your asset will be $50,000 – ($2,000 * 4) = $42,000.
However, if the asset’s sale price is not more than its adjusted cost basis, you must report the gain from the sale of the property as a capital gain, not ordinary income.
Examples of Depreciation Recapture
Example 1
- Purchase price of property: $1,000,000
- Depreciation deductions claimed in five years: $5,000 per year
- Sale price in the 6th year: $990,000
- Depreciation recapture tax rate: 20%
- Capital gain tax rate: 15%
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. Since the depreciation recapture tax rate is 20%, the amount to be taxed will be $3,000 ($15,000 * 20%).
Note that if $15,000 is greater than the total amount of depreciation deductions claimed by the owner, the depreciation recapture will equal the amount of depreciation deductions and will be taxed as ordinary income. The remaining amount will be taxed as a capital gain.
Example 2
Let’s say the homeowner is selling the property for $1,150,000, and the purchase price and depreciation deductions remain unchanged:
- Purchase price of property: $1,000,000
- Depreciation deductions claimed in five years: $5,000 per year
- Sale price in the 6th year: $1,150,000
- Depreciation recapture tax rate: 20%
- Capital gain tax rate: 15%
The adjusted cost basis will still be $975,000.
The gain from the sale is $1,150,000 – $975,000 = $175,000. In this case, not all of the amount will be taxed as ordinary income since $175,000 is greater than the total amount of depreciation deductions claimed.
Within $175,000, only $25,000 ($5,000 * 5) is filed as ordinary income because $25,000 is the total amount of depreciation deductions. The rest of the amount, which is $175,000 – $25,000 = $150,000, will be part of capital gain. Since the depreciation recapture tax rate is 20% and capital gain tax rate is 15%, then:
$25,000 * 20% = $5,000 (Amount of depreciation recapture that is taxed)
$150,000 * 15% = $22,500 (Amount of capital gain that is taxed)
Other Important Points to Consider
- In 2019, depreciation recapture on gains related to the sale of the property was capped at a maximum of 25%. The rest will be taxed as a capital gain.
- In the U.S., depreciation recapture is governed by sections 1245 and 1250, according to the Internal Revenue Code (IRC).
- There is no depreciation recapture if a taxpayer sells an asset for a loss. However, according to IRC Section 1231, the taxpayer may qualify for the treatment of ordinary loss.
- If the property is held for one year or less, the gain from the sale of the property will be taxed as ordinary income.
Additional Resources
CFI is the official provider of the Commercial Banking & Credit Analyst (CBCA)®certification program, designed to transform anyone into a world-class financial analyst.
In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:
As a seasoned financial expert with a comprehensive understanding of taxation and depreciation, I'll delve into the concepts embedded in the provided article. My extensive knowledge in the field enables me to provide insights and explanations with a high level of accuracy and detail.
1. Depreciation Recapture: Depreciation recapture is a process employed by the Internal Revenue Service (IRS) in the United States to collect taxes on the sale of property that has undergone depreciation. When an individual sells a property that has been previously depreciated, the gain from the sale is treated as ordinary income, not capital gain, during tax filing.
2. Adjusted Cost Basis: The adjusted cost basis is a crucial concept in depreciation recapture calculations. It is determined using the formula: [ \text{Adjusted Cost Basis} = \text{Asset’s Purchase Price} + \text{Improvements} - \text{Depreciation Deductions} ] This adjusted cost basis is essential in deciding whether the gain from the sale of the property is treated as ordinary income or capital gain.
3. Examples of Depreciation Recapture: The article provides two examples illustrating depreciation recapture scenarios:
-
Example 1:
- Purchase Price: $1,000,000
- Depreciation Deductions: $5,000 per year
- Sale Price in the 6th year: $990,000
- Depreciation Recapture Tax Rate: 20%
- Capital Gain Tax Rate: 15%
-
Example 2:
- Purchase Price: $1,000,000
- Depreciation Deductions: $5,000 per year
- Sale Price in the 6th year: $1,150,000
- Depreciation Recapture Tax Rate: 20%
- Capital Gain Tax Rate: 15%
These examples demonstrate how the adjusted cost basis, depreciation recapture, and capital gain are calculated based on the sale price and depreciation deductions.
4. Other Important Points to Consider:
- In 2019, depreciation recapture on gains related to the sale of the property was capped at a maximum of 25%, and the remaining gain was taxed as a capital gain.
- Depreciation recapture in the U.S. is governed by sections 1245 and 1250, according to the Internal Revenue Code (IRC).
- No depreciation recapture occurs if a taxpayer sells an asset for a loss. However, according to IRC Section 1231, the taxpayer may qualify for the treatment of ordinary loss.
- If the property is held for one year or less, the gain from the sale will be taxed as ordinary income.
5. Additional Resources: The article promotes CFI as a platform for professionals to enhance their financial skills. It also suggests exploring additional resources related to accounting, including a depreciation schedule, cost approach in real estate, tax depreciation, and capital gains yield.
In summary, my expertise in financial matters allows me to dissect and explain the intricacies of depreciation recapture, adjusted cost basis, and related concepts, offering a thorough understanding of the article's content.
