Depreciation Recapture: What It Is and How to Calculate It
Depreciation recapture is a tax provision that requires you to pay back some of the tax savings you received from depreciating an asset. Businesses are subject to depreciation recapture when they sell commercial property or business assets at a profit after claiming depreciation deductions.
This process significantly impacts some small and medium-sized businesses’ tax liability, as the recaptured amount is often taxed at ordinary income rates rather than capital gains rates. Understanding how depreciation recapture works—and how to calculate it—is essential for effective tax planning and avoiding unexpected costs.
Depreciation Recapture Explained
Depreciating an asset allows you to reduce your taxable income by accounting for its gradual loss in value. For some, this leads to significant tax savings over time.
Depreciation recapture applies if the business eventually sells the asset for more than its adjusted basis (the original purchase price minus the accumulated depreciation). The portion of your gain that resulted from previous depreciation deductions will be taxed at higher, ordinary income tax rates (up to 37 percent) instead of the typically lower capital gains rates (0, 15, or 20 percent). Be aware that real property, like rental properties or commercial buildings, is subject to slightly different tax treatment when sold for a gain.
Depreciation recapture is a potentially significant expense for small businesses. That's why it's important to leverage expert insights by tax planning professionals to minimize its impact proactively.
What Is the Purpose of Depreciation Recapture?
The main purpose of depreciation recapture is to prevent tax shelter abuse. Without it, taxpayers could deduct large amounts of depreciation to lower their taxable income during ownership, then sell the asset and pay only capital gains tax on the profit.
Depreciation recapture closes that loophole. It ensures any tax benefits received through depreciation are eventually recuperated when the asset is sold. This makes the tax treatment of asset sales more equitable and discourages strategies aimed purely at tax avoidance.
Avoiding taxes like depreciation recapture altogether is complicated for fixed asset sales. One of the biggest tax advantages of leasing equipment vs buying it is avoiding costly depreciation recapture. Strategic tax planning allows you to minimize the tax implications of selling business property if you do decide to buy.
How Is Depreciation Recapture Triggered?
Depreciation recapture is triggered when you sell a depreciated asset for more than its adjusted basis. This reduced value reflects the asset’s current book value for tax purposes, not its market value.
The difference between the sale price and the adjusted basis (the realized gain) will then be analyzed. This is divided into two parts:
Depreciation Recapture: The portion of the profit equal to the depreciation you claimed over the asset's life. This part is taxed as ordinary income.
Capital Gain: Profits on top of the recaptured depreciation are subject to capital gains tax.
Recapture Rules by Property Type
|
Property Type |
Section |
Examples |
Tax Treatment |
|
Personal Property |
1245 |
Equipment, machinery, vehicles |
All depreciation is recaptured as ordinary income, up to the amount of gain. |
|
Real Property |
1250 |
Commercial buildings, rental units |
Only accelerated depreciation is recaptured as ordinary income. Straight-line depreciation is taxed at a maximum 25 percent rate (unrecaptured Section 1250 gain). |
Commercial buildings, rental units
Only accelerated depreciation is recaptured as ordinary income. Straight-line depreciation is taxed at a maximum 25 percent rate (unrecaptured Section 1250 gain).
Note: Most commercial and residential rental properties use straight-line depreciation, so only the 25 percent “unrecaptured” gain rule usually applies.
How to Calculate Depreciation Recapture
Most depreciation recapture applies to 1245 property. Here's a step-by-step breakdown of how it works:
Determine the Original Purchase Price (Cost Basis)
Start with the amount you paid for the asset, including any costs directly related to acquiring it (like delivery or installation fees).Subtract Accumulated Depreciation
Calculate the total depreciation you’ve claimed on the asset during the time you owned it.Cost Basis - Depreciation = Asset's Adjusted Cost Basis
Determine the Sale Price
This is the amount you received when you sold the asset, minus any selling costs (like commissions or legal fees).Calculate the Total Gain
Subtract the adjusted basis from the sale price:Sale Price - Adjusted Basis = Total Gain
Identify the Recaptured Depreciation
Compare the total gain to the accumulated depreciation:The lesser of the total gain or the accumulated depreciation is taxed as recaptured depreciation (subject to ordinary tax rates).
Classify Remaining Gain (If Any)
If your total gain exceeds the depreciation taken, the excess is treated as a capital gain:
Depreciation Recapture -> Ordinary Income Tax Rate
Remaining Gain -> Capital Gain Tax Rate
Example:
Let’s say you purchased equipment for $50,000 and claimed $30,000 in depreciation.
Adjusted Basis = $50,000 - $30,000 = $20,000
You sell it for $40,000
Total Gain = $40,000 - $20,000 = $20,000
Since $20,000 < $30,000, the entire gain is recaptured depreciation taxed at ordinary income rates.
|
Component |
Amount |
Tax Treatment |
|
Original Purchase Price |
$50,000 |
– |
|
Depreciation Claimed |
$30,000 |
Used to calculate adjusted basis |
|
Adjusted Basis |
$20,000 |
Original cost - depreciation |
|
Sale Price |
$40,000 |
– |
|
Total Gain |
$20,000 |
Sale price - adjusted basis |
|
Depreciation Recapture |
$20,000 |
Taxed as ordinary income (up to 37 percent) |
|
Capital Gain |
$0 |
No capital gain, since gain ≤ depreciation |
|
Total Taxable Gain |
$20,000 |
Flows into total income, taxed at ordinary rates |
Calculating Depreciation Recapture for 1250 Property
Imagine a commercial building that was fully depreciated using straight-line depreciation:
Original purchase price of building: $400,000
Depreciation taken over time (straight line method): $100,000
Adjusted basis: $400,000 - $100,000 = $300,000
Sale price: $450,000
Step-by-Step Calculation:
1. Calculate Total Gain
Sale price - Adjusted basis =
$450,000 - $300,000 = $150,000 gain
2. Determine Depreciation Recapture
Since this is Section 1250 property (real property), and the depreciation was straight-line, there's typically no depreciation recaptured at ordinary income tax rates.
However, the portion of gain attributable to depreciation ($100,000) is taxed as unrecaptured Section 1250 gain at a maximum 25 percent rate, not as capital gain or ordinary income.
So:
$100,000 → taxed at up to 25 percent as unrecaptured Section 1250 gain
Remaining $50,000 → taxed as long-term capital gain (15 or 20 percent)
How It Breaks Down on the Tax Return:
|
Portion of Gain |
Amount |
Tax Treatment |
|
Depreciation taken |
$100,000 |
Unrecaptured 1250 gain (max 25 percent) |
|
Gain above original cost |
$50,000 |
Capital gain (0, 15, or 20 percent) |
|
Total Gain |
$150,000 |
Note: Most commercial and residential rental properties use straight-line depreciation, so only the 25 percent “unrecaptured” gain rule usually applies.
How Depreciation Recapture Works on Your Tax Return
Here’s how depreciation recapture typically shows up on your tax return:
Form 4797: This form is used to report the sale of business property, including depreciation recapture. Part III of Form 4797 calculates the recapture amount.
Schedule D: If part of your gain qualifies as a capital gain, you’ll report it here.
Form 1040: The recaptured depreciation flows through to your main tax return and is added to your taxable income.
Understanding how depreciation recapture is treated on your return helps you prepare for any tax liability that arises from selling business assets. Consulting a tax professional will also help ensure you file accurately and take advantage of the available strategies to minimize your tax burden.
How to Minimize Depreciation Recapture
Depreciation recapture sometimes leads to a higher tax bill when you sell a depreciated asset. However, there are legitimate strategies to reduce or defer the amount you owe. Here are three commonly used methods:
1. 1031 Tax-Deferred Exchange
A 1031 exchange, AKA “like-kind exchange,” enables you to defer capital gains and depreciation recapture taxes by reinvesting the profits from the sale of a business or investment property into a comparable property.
You won’t owe taxes on the gain or the recaptured depreciation until you sell the replacement property if the exchange follows IRS rules. This strategy is popular with investors looking to grow their portfolios without triggering immediate tax liability, as it defers capital gains tax.
2. Section 121 Exclusion (Primary Residence Exemption)
You may qualify for the Section 121 exclusion if the property you’re selling was your primary residence for at least two of the past five years. This rule allows you to exclude up to $250,000 of gain from your taxable income (or $500,000 for married couples filing jointly). Be aware that this exclusion generally doesn’t apply to depreciation recapture from periods when the home was used as a rental or for business purposes.
3. Tax-Loss Harvesting
You may be able to sell assets that have lost value at a loss to offset some or all of the gains from the sale of your asset (including depreciation recapture). This strategy, known as tax-loss harvesting, is useful for reducing your overall tax liability in years when you have capital gains.
FAQs
Are Heirs Subject to Depreciation Recapture?
Heirs aren't typically liable to pay depreciation recapture. This is because inherited assets receive a step-up in basis to their fair market value at the time of death, effectively eliminating any prior depreciation.
Are Depreciation Recapture and Capital Gains Tax the Same?
Depreciation recapture and capital gains tax aren't the same. Depreciation recapture taxes the portion of gain related to previously claimed depreciation at ordinary income rates (up to 25 percent for real estate), while capital gains tax applies to any remaining gain and is usually taxed at lower rates.
Does Depreciation Recapture Apply to Primary Residences?
Depreciation recapture doesn't generally apply to primary residences because they are not depreciated for tax purposes. The exception is if you claimed depreciation on part of your home, such as for a home office or rental use. Recapture may apply to that portion when you sell your home.
Plan Ahead to Minimize the Impact of Depreciation Recapture
Depreciation provides valuable tax savings during ownership, but those benefits may need to be partially repaid when the asset is sold—often at higher ordinary income tax rates. Understanding when and how depreciation recapture applies, the difference between Section 1245 and 1250 property, and how to calculate it accurately is essential for effective tax planning.
Being aware of depreciation recapture rules allows you to avoid surprises and plan ahead. Work with a qualified tax professional to apply strategies to minimize or defer the impact.
