Tax Planning Tips for Depreciation Recapture

Depreciation Recapture Can Have a Significant Impact on Your Taxes

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Some capital assets can be depreciated for tax purposes, spreading the cost of an asset over a period of time for purposes of tax deductions.  As a result, depreciation reduces the asset's adjusted cost basis. When the asset is subsequently sold, the gain on the sale will be more because its basis is now lower. How the gain is treated depends on the type of asset in question.

Depreciation Recapture and Residential Rental Properties 

Depreciation recapture can cause a significant tax impact when you sell a residential rental property.

Part of the gain is taxed as a capital gain and may qualify for the maximum 15 percent rate on long-term gains, but the part that is related to depreciation is taxed at a maximum 25 percent rate. The technical term for gain related to depreciation on residential property is “unrecaptured section 1250 gain.”

Tax Planning Tips for Depreciation Recapture

Any passive activity losses that were not deductible in previous years become fully deductible when a rental property is sold. This can help offset the tax bite of the depreciation recapture tax.

A Rental property can also be sold as part of a like-kind exchange to defer both capital gains and depreciation recapture taxes. This involves disposing of an asset and immediate acquiring another similar asset, effectively deferring taxes until a later point in time when eventually a sale is not followed by an acquisition.

Avoiding Claiming Depreciation Won't Help 

It might seem reasonable that you could avoid claiming depreciation as a strategy to avoid the recapture tax hit because it must be recaptured when the asset is sold.

This strategy doesn’t work because tax law requires that recapture be calculated on depreciation that was "allowed or allowable," according to Internal Revenue Code section 1250(b)(3). In other words, you were entitled to claim depreciation even if you didn’t so the IRS treats the situation as though you had.

From a tax-planning perspective, taxpayers should generally claim depreciation on property to get the current associated tax deduction because they’ll have to pay tax on the gain due to the depreciation anyway when they eventually sell.

Additional Resources About Depreciation Recapture

Here are some additional resources from the IRS website regarding depreciation. I've found helpful and informative over the years: 

NOTE: Tax laws change periodically, and you should consult with a tax professional for the most up-to-date advice. The information contained in this article is not intended as tax advice and is not a substitute for tax advice.