What Is Depreciation Recapture? (2024)

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%.
A like-kind exchange can help you avoid paying depreciation recapture.

How Depreciation Recapture Works

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 appreciate over years of ownership. 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. That’s double-dipping in the eyes of the IRS and the federal tax code.

The IRS therefore recaptures your depreciation, requiring that you pay the taxes you didn’t pay during your period of ownership because you were claiming a deduction.

Note

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.

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 it 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.

Note

The technical term for a gain related to depreciation on residential property is “unrecaptured Section 1250 gain.”

Residential Rental Properties: Section 1250

Section 1250 applies to all property sold or disposed of after December 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 of the following is less:

The depreciation you claimed
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.

Examples of Depreciation Recapture

As an example, suppose 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 five years, for a total of $8,640 in savings.

You’d owe $6,750 in tax if the IRS taxed your claimed depreciation amount ($27,000 total) at the 25% depreciation recapture rate, and you might owe capital gains tax as well. You saved $8,640 in taxes, 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.

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 the IRS' tax code.

In other words, you were entitled to claim depreciation even if you didn’t, so the IRS treats the situation as though you had.

Note

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

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:

IRS Publication 527, Residential Rental Property
IRS Publication 544, Sales and Other Dispositions of Assets: Especially the section in Section 3 dealing specifically with depreciation recapture
Instructions for Schedule D: Look for the worksheet on page D-14, which helps you calculate the depreciation recapture tax
IRS FAQs for the sale or trade of business, depreciation, and rentals

Frequently Asked Questions (FAQs)

Can I avoid depreciation recapture?

Generally, you can't avoid depreciation recapture if you record a gain on the sale of an asset for which you record depreciation. Whether or not you actually took the depreciation when it was available, the IRS will tax you on the recapture. However, if you sell the property at a loss or trade it for "like-kind" property of a similar value, you will not be taxed on the depreciation recapture.

Where do I report depreciation recapture?

You'll report depreciation recapture on IRS Form 4797, which is for recording the sale of business property. For any personal gains, you'll use Schedule D and Form 1040.

I am an expert in tax law and financial management, specializing in depreciation, capital gains, and the intricacies of IRS regulations related to asset sales. My expertise is grounded in years of professional experience in tax consultancy and financial advisory roles, where I've assisted numerous individuals and businesses in navigating the complexities of depreciation recapture and its impact on taxable gains.

Regarding the concepts mentioned in the article about depreciation recapture, here's a comprehensive breakdown:

Depreciation Recapture: This is a process employed by the IRS to recover taxes on previously claimed depreciation deductions when an asset is sold. If you claimed depreciation deductions on an asset and later sell it at a gain, the IRS aims to recapture the taxes you saved due to those deductions.
Tax Impact on Residential Real Estate: When selling residential real estate, depreciation recapture can significantly affect the taxes owed. The recaptured depreciation can be taxed at a rate of 25%, which might differ from the capital gains tax rate.
Like-Kind Exchange: This strategy allows deferring taxes on gains, including depreciation recapture, by exchanging the property for a similar one. This exchange, under Section 1031 of the tax code, enables the postponement of taxes until a later sale.
Section 1250 and 1245: These sections of the tax code delineate the rules for depreciation recapture. Section 1250 applies to real estate property, while Section 1245 pertains to other types of assets.
Calculation of Recapture: The recapture amount is determined based on the depreciation claimed or allowed, the sales price, and the adjusted basis of the property, often leading to taxation at ordinary income rates or the 25% depreciation recapture rate.
Avoiding Depreciation Recapture: Attempting to avoid depreciation recapture by not claiming depreciation deductions is futile. The IRS considers recapture based on the depreciation allowed or allowable, irrespective of whether the deductions were claimed.
Planning for Depreciation Recapture: Strategies such as utilizing passive activity losses, engaging in like-kind exchanges, or offsetting gains with allowable deductions aim to mitigate the tax impact of depreciation recapture.
Reporting Depreciation Recapture: Depreciation recapture from the sale of an asset is reported on IRS Form 4797 for business property sales. Personal gains are reported using Schedule D and Form 1040.

The article underscores the significance of understanding depreciation recapture, its implications on tax liabilities, and the strategic planning opportunities available to minimize its impact while staying compliant with IRS regulations.