Depreciation Recapture Guide: What Is Depreciation Recapture?

Depreciation recapture is a mechanism in the internal revenue code (IRC) through which the IRS can assess a tax on the profitable sale of an asset for which you claimed depreciation-related tax deductions. The tax rate you pay will depend upon the sale price of your capital asset and the accumulated depreciation expenses you claimed on your prior tax returns.

Depreciation recapture can apply to any depreciable assets for which you've received tax deductions in the past. The mechanism particularly applies to real estate investors who have made long-term capital gains on a rental property or investment property. However, real estate is not the only type of business or personal property that can be eligible for depreciation-related tax deductions. A business's furniture or equipment may also be considered depreciable property. This means property owners can lower their ordinary income tax by claiming a depreciation, but the IRS can also recoup some of that money when the owners sell their property.

Depreciation recapture taxes almost never apply to a residential property used as a primary home. However, when you purchase an investment property or when you own a residential rental property, you may find yourself declaring an annual depreciation of your real property for tax purposes. When the time comes to sell the property at present market value, you may very well turn a profit since real estate value typically goes up over time. At this point, the IRS may step in to recoup some of the taxes you did not pay when you claimed depreciations. In other words, the tax law considers your profits to be taxable income and subject to a capital gains tax bill.

To understand how depreciation recapture is calculated, it’s necessary to understand depreciations themselves. Companies and individuals can lower their ordinary income tax rate by claiming depreciation on capital properties. The IRS publishes depreciation schedules that show the allowable annual depreciation a taxpayer can claim on a piece of property. These schedules also note what the IRS considers to be an asset’s useful life. For instance, the agency’s Modified Accelerated Cost Recovery System (MACRS) considers the useful life of a rental property to be twenty-seven and one-half years.

When depreciable assets are held for over one year, the IRS considers them Section 1231 property, which is governed by Section 1231 of the IRS code. Two types of capital assets exist within Section 1231 of the IRS code. One type is a capital asset that is not real estate, like machinery. The other type is an asset that is real estate—including land and buildings. The IRS may tax these assets in different ways.

• Non-real-estate depreciation: The IRS begins by assessing the adjusted cost basis of these assets. For instance, a company's printing press may have cost $50,000, but after several years of annual depreciation expenses, its adjusted cost basis is now $21,000, which means its total depreciation expenses were $29,000. The tax liability depends upon whether that printing press is sold for a profit. If its adjusted cost basis is $21,000 but the company manages to sell it for $26,000, the IRS assesses a $5,000 profit from that purchase price. This is called a realized gain. Next, the IRS determines which is lower: the realized gain or the total depreciation expenses. In this case, the $5,000 realized gain is lower than the $29,000 depreciation expense, and so the depreciation recapture will be $5,000. The company must pay tax on that $5,000 and it does so at the ordinary income rate for its tax bracket. There are also cases where depreciation recapture is taxed at a capital gains rate, which is lower than the ordinary income rate. Consult a tax professional for further guidance.
• Real estate depreciation: These assets are found in real estate investing. They include both land and any structures built on the land. Most real estate investors use the straight-line depreciation method. When this is the case, depreciation recapture is taxed at two different rates. The gain beyond the property's original cost basis gets taxed at the capital gains rate (which, again, is lower than the ordinary income rate). However, the gain that is directly related to depreciation recapture is taxed at a special tax rate for unrecaptured gains. This rate is higher than the capital gains tax rate but lower than the ordinary income rate. As with non-real-estate depreciations, the formula can be complicated, so consult a tax professional for the most thorough guidance.

Depreciation recapture is important for tax planning purposes. When you sell real property (whether it be real estate or other capital assets) for a profit, you will need to pay taxes on that profit. Depreciation recapture triggers a specific type of tax that only applies if you've taken tax deductions related to depreciation on your property.

A certified public accountant (CPA) that specializes in real estate or corporate finance will be able to help you plan for depreciation recapture and make sure that you pay the amount you owe the IRS.

All investments and investment strategies entail inherent risks and introduce the potential for financial loss or the depreciation of assets. The information presented in this article is for educational, informational, and referential purposes only. Consult a professional investment advisor before making any financial commitments.

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