The value of some capital assets can be depreciated for tax purposes. You can divide and spread out the cost of an asset over several years of its useful life and take a tax deduction for that amount in each of those years, but the Internal Revenue Service (IRS) stands by to collect those taxes eventually. The IRS will collect when and if you sell the asset in question … or even if you don’t in some cases. This concept is referred to as “depreciation recapture.”
Understanding the limits to depreciation recapture and the tax rates that apply can help you plan the best scenario when you sell.
What Is Depreciation Recapture?
Not all assets depreciate at the same rate. Automobiles are notorious for losing value the moment you drive a new one off the dealership lot, but real estate can actually appreciate over years of ownership. That’s double-dipping in the eyes of the IRS and the federal tax code if you claim a depreciation deduction during those years as well. You might also realize a profit and a capital gain if you sell the property for more than your cost basis in it, but you were taking a tax deduction for its decreasing value over those years of ownership.
A capital gain is the difference between an asset’s adjusted cost basis and what you sell it for, and capital gains are taxable. Reducing the asset’s basis through depreciation results in more of a gain.
The IRS therefore recaptures your depreciation, requiring that you pay the taxes you didn’t during your period of ownership because you were claiming a deduction.
How Depreciation Recapture Works
Depreciation recapture can cause a significant tax impact if you sell a residential rental property. Part of the gain can be taxed as a capital gain and this might qualify for the maximum 20% rate on long-term gains, but the part that’s related to depreciation can be taxed at the 25% depreciation recapture rate.
The technical term for a gain related to depreciation on residential property is “unrecaptured Section 1250 gain.”
As an example, let’s say you purchased a rental property for $150,000. You depreciated it for tax purposes at a rate of $5,400 a year for five years. You were in the 32% tax bracket in each of those years, so you avoided $1,728 each year in taxes that you didn’t have to pay: 32% of $5,400, for a total of $8,640 in savings.
You’ve claimed a total of $27,000 in depreciation over five years of ownership: $5,400 times five. You’d owe $6,750 in tax if the IRS taxed this at the 25% depreciation recapture rate, and you might owe capital gains tax as well. You saved $8,640 in taxes ($1,728 times five years), so you’re actually only seeing a profit of $1,890—the difference between $6,750 and $8,640—because the IRS effectively reclaimed that depreciation.
Examples of Depreciation Recapture
How your gain is recaptured depends on the type of asset in question. Section 1250 of the tax code applies to real estate property, whereas Section 1245 applies to other types of assets. Each sets forth the circumstances under which recapture can be taxed as ordinary income, rather than at the 25% rate.
Residential Rental Properties: Section 1250
Section 1250 applies to all property sold or disposed of after Dec. 31, 1975. It provides that any gain on the sale of a property may be taxed as ordinary income, according to your marginal or top tax bracket, based on whichever is less:
- The depreciation you claimed, or
- The difference between the sales price or fair market value (in the event that you don’t sell the property) and the adjusted basis of the property
Otherwise, it’s subject to the 25% rate, rather than the more advantageous capital gains rate.
Other Property: Section 1245
Section 1245 applies to property not including “a building or its structural components.” according to the tax code. A portion of this property is taxed as ordinary income to the extent that the sales price exceeds the lesser of:
- The “recomputed” basis of the property by adding back deductions
- The sales price or the asset’s fair market value
Again, the recapture is otherwise taxed at the 25% rate, not at the more favorable capital gains tax rate.
Not Claiming Depreciation Won't Help
It might seem reasonable that you could not claim a depreciation deduction to avoid paying the recapture tax. This strategy doesn’t work, however, 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.
Taxpayers should generally claim depreciation on the property to get the associated tax deduction because they’ll have to pay tax on the gain due to the depreciation anyway, when and if they eventually sell.
How to Plan for Depreciation Recapture
Now here's some good news. Passive activity losses that were not deductible in previous years have become fully deductible when a rental property is sold. This can help offset the tax bite of the depreciation recapture tax.
A rental property also can 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 immediately acquiring another similar asset, effectively deferring taxes until a later point when a sale is not followed by an acquisition.
Additional Resources About Depreciation Recapture
Here are some additional resources from the IRS website regarding depreciation that you might find helpful:
- Residential Rental Property (IRS Publication 527).
- Sales and Other Dispositions of Assets (IRS Publication 544, especially the section in Section 3 dealing specifically with depreciation recapture).
- Instructions for Schedule D (There's a worksheet found on page D-14 to calculate the depreciation recapture tax).
- FAQ: Sale or Trade of Business, Depreciation, Rentals (an IRS FAQ).
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.