Depreciation Recapture

Depreciation recapture is a tax provision used by the Internal Revenue Service (IRS) to reclaim the benefits of depreciation that have been used to reduce taxable income. When an investor or company sells a depreciated asset for a price higher than its adjusted cost basis (its original value minus the depreciation deductions), the IRS imposes taxes on the gains associated with the depreciation. This process is known as depreciation recapture.

To understand this concept, it’s important to first grasp how depreciation works. Depreciation is a method that allows taxpayers to deduct the decrease in value of an asset over its useful life. For example, real estate investors can depreciate properties over a set number of years, helping reduce taxable income. However, when that asset is sold for a profit, the IRS aims to "recapture" the depreciation deductions taken by taxing the gain attributable to the depreciation.

Depreciation recapture is reported on IRS Form 4797 and applies to various types of depreciated assets, including real estate, machinery, and equipment. The rate at which depreciation recapture is taxed depends on the type of asset, with different tax treatments for non-real estate and real estate property.

Related: What Is Depreciation In Real Estate?

Key Concepts of Depreciation Recapture

1. Ordinary Income Tax Rate vs. Depreciation Recapture Rate: Depreciation recapture on non-real estate assets is taxed at the taxpayer's ordinary income tax rate, which can be higher than the capital gains tax rate. In contrast, for real estate, the depreciation recapture is capped at a maximum of 25%.
2. Adjusted Cost Basis: The adjusted cost basis refers to the original cost of the asset minus any accumulated depreciation. When an asset is sold, the depreciation recapture is calculated as the difference between the sale price and the adjusted cost basis. This amount is then subject to taxation.

Depreciation Recapture in Real Estate

Depreciation recapture is particularly important for real estate investors. The IRS allows investors to depreciate real estate assets over their "useful life" to account for the wear and tear of buildings or property. Residential rental properties, for instance, can be depreciated over 27.5 years, while commercial properties can be depreciated over 39 years.

When a real estate asset is sold, any gain that exceeds the adjusted cost basis triggers a depreciation recapture event. For real estate, the depreciation recapture tax rate is capped at 25%. However, any part of the gain that exceeds the original cost basis is taxed at the long-term capital gains tax rate, which may be lower than 25%.

Example of Depreciation Recapture in Real Estate

To better illustrate how depreciation recapture works, consider the following example:

• In 2005, you purchased a residential rental property for $350,000, with $75,000 allocated for the land value. Since land is non-depreciable, the original cost basis for the property is $275,000.
• You depreciate the property over 27.5 years, which provides an annual depreciation deduction of $10,000.
• After 15 years of ownership, you decide to sell the property for $430,000.
• Over the 15 years, you’ve claimed $150,000 in total depreciation ($10,000 x 15 years). As a result, the adjusted cost basis for the property is $125,000 ($275,000 - $150,000).

When the property is sold, two types of taxes are triggered:

• Capital Gains Tax: The capital gain is calculated as the difference between the sale price and the original purchase price: $430,000 - $350,000 = $80,000. This amount is taxed at the long-term capital gains rate.
• Depreciation Recapture Tax: The depreciation recapture is calculated based on the difference between the adjusted cost basis and the sale price: $430,000 - $125,000 = $305,000. The portion related to depreciation ($150,000) is taxed at the depreciation recapture rate (capped at 25%).

Thus, in this scenario, if the long-term capital gains tax rate is 20%, you would owe $16,000 in capital gains tax (20% of $80,000) and $32,500 in depreciation recapture tax (25% of $150,000), for a total tax liability of $48,500.

How to Calculate Depreciation Recapture

The calculation for depreciation recapture follows these steps:

1. Determine the adjusted cost basis of the asset by subtracting the depreciation deductions from the original purchase price.
2. Subtract the adjusted cost basis from the sale price to calculate the gain on the sale.
3. Apply the appropriate tax rates based on whether the asset is real estate or another type of property.

For real estate, the portion of the gain attributable to depreciation is taxed at a maximum rate of 25%, while the remaining gain is taxed as capital gains.

Depreciation Recapture for Section 1245 and 1250 Assets

Depreciation recapture rules vary depending on the type of asset. Under IRS code:

• Section 1245 assets include machinery, equipment, and other non-real estate property. Depreciation recapture on these assets is taxed at the taxpayer's ordinary income tax rate.
• Section 1250 assets refer to real estate property, such as buildings or land improvements. For these assets, depreciation recapture is capped at 25%.

Avoiding Depreciation Recapture

One way to defer depreciation recapture is through a 1031 exchange, which allows investors to defer taxes by reinvesting the proceeds from the sale into a similar property. However, the recapture tax is deferred, not eliminated, and will eventually be owed if the investor sells the replacement property without a further exchange.

What Is Depreciation Recapture? Conclusion

While depreciation allows taxpayers to take reduce their rental income tax bill the IRS will recoup a portion of the depreciated amount when the asset is sold through depreciation recapture. Accurate tracking and reporting of depreciation are crucial to avoid costly surprises when calculating taxes.

Tools like Landlord Studio help investors stay on top of depreciation deductions and streamline the process of preparing for tax filings.