Depreciation recapture is the gain realized by the sale of depreciable capital property that must be reported as ordinary income for tax purposes. This recapture occurs when the sale price of an asset exceeds its adjusted cost basis. The difference between these figures is thus “recaptured” by reporting it as ordinary income.
Key Takeaways
- Depreciation recapture allows taxing the profitable sale of an asset previously used to offset taxable income.
- Non-real estate property depreciation recapture is taxed at the ordinary income tax rate.
- Real estate depreciation recapture is capped at a maximum of 25%.
- To calculate, compare the adjusted cost basis of the asset to its sale price.
Understanding Depreciation Recapture
Companies account for wear and tear on property, plant, and equipment through depreciation, spreading the cost associated with the use of an asset over a number of years. Specific depreciation schedules published by the IRS guide on the percentage of an asset’s value deductible each year.
For tax purposes, depreciation expenses lower the ordinary income and reduce the asset’s adjusted cost basis annually. When a depreciated asset is sold for a profit, the ordinary income tax rate applies to the depreciation previously taken.
Sections in Depreciation Recapture
Depreciable capital assets held for over a year fall under Section 1231 property in the IRS Code, further divided into Section 1245 (non-real estate) and Section 1250 (real estate). Tax rate for recapture varies accordingly.
Examples of Depreciation Recapture
Section 1245 Depreciation Recapture
To understand, first determine the cost basis: the initial price paid minus any allowed depreciation. For example, if equipment bought for $10,000 incurs $2,000 annual depreciation, the adjusted basis after four years is $2,000.
If sold for $3,000, the gain of $1,000 is taxable. However, if sold for $12,000, all accumulated depreciation becomes ordinary income, and anything beyond that—$2,000 in this case—is a capital gain taxed favorably.
Section 1250 Depreciation Recapture
Unlike non-real estate, real estate recapture isn’t taxed as ordinary income if straight-line depreciation is used. Instead, gain calculated from depreciation is taxed up to 25%. For a property bought at $275,000 and sold at $430,000 after 11 years, recapture and gains are calculated specifically.
If annual depreciation taken is $110,000 by this period, and assuming favorable capital gains and income tax rates, the adjusted tax on gains of this property comes out to be notably substantial.
Calculating Depreciation Recapture
Depreciation recapture is computed by subtracting the adjusted cost basis from the sale price. For instance, an asset sold at $3,000 with an adjusted cost basis of $2,000 gives a $1,000 gain, taxable depending on the asset’s type and owner’s tax bracket.
Treatment of Depreciation Recapture
Generally treated as ordinary income, real estate’s gain beyond original cost basis counts as capital gain. Differentiating tax treatment leverages rates capped at specific levels—particularly for real estate.
Minimizing Depreciation Recapture
While selling a property for less isn’t favorable, utilizing an IRS Section 121 exclusion or estate transfers might offset recapture. Expert consulting is recommended for such strategies.
The Bottom Line
Depreciation recapture enables the IRS to tax the profitable sale of an asset depreciated to reduce taxable income. Accurate calculation involves adjusted cost basis and sale price, with differentiated tax treatment for real estate. Understanding nuances aids in optimizing financial and tax planning effectively.
Related Terms: ordinary income, cost basis, capital gains tax, adjusted cost basis, accumulated depreciation.
References
- Internal Revenue Service. “Publication 544 Sales and Other Dispositions of Assets”, Pages 2-3, 26-33, 36.
- Internal Revenue Service. “Topic No. 409 Capital Gains and Losses”.
- Internal Revenue Service. “1.35.6 Property and Equipment Accounting”.
- Internal Revenue Service. “Instructions for Form 4562”, Pages 1-2.
- Internal Revenue Service. “Publication 946, How to Depreciate Property”.
- Internal Revenue Service. “IRS provides tax inflation adjustments for tax year 2023”.
