Depreciation recapture tax

What is depreciation recapture tax?

Depreciation recapture tax is a method the IRS uses to collect taxes on the sale of a depreciated asset the taxpayer has held for more than a year and was used to offset taxable income, assuming the asset was sold at a gain. In other words, it enables the IRS to “recapture” what it considers to be taxable income lost through depreciation. If the asset is sold at a loss, there is no depreciation recapture because there is no income or gain to be taxed.

Depreciation recapture applies to two categories of assets — Section 1250 and Section 1245 — and the depreciation recapture tax rate depends on the asset's categorization.

Which assets are subject to depreciation recapture?

Assets categorized as either Section 1245 or Section 1250 assets are generally subject to depreciation recapture. If an asset is sold at a loss, there is no depreciation recapture since there is no income or gain to be taxed.

Section 1245 includes depreciation recapture on personal property like machines, vehicles, furniture, etc. These are taxed at ordinary tax rates.

Section 1250 includes depreciation recapture on real property like rental properties, warehouses, and commercial buildings. The IRS recoups the total depreciation expense to lower the taxpayer’s taxable net income. The taxpayer’s ordinary income tax rate applies, capped at 25%.

However, when it comes to section 1250 property, it is important to be aware that there are two types of depreciation recapture — section 1250 recapture and unrecaptured section 1250.

Section 1250 recapture refers to the portion of the long-term capital gain that exceeds the original cost basis and is taxed as a capital gain. The unrecaptured section 1250 refers to the portion of the long-term capital gain associated with depreciation, and it is taxed at a maximum rate of 25%.

How do you calculate depreciation recapture?

Calculating depreciation recapture is done by determining the difference between the asset’s adjusted cost basis and the asset’s sale price. When calculating depreciation recapture, consider the following steps:

Determine the asset’s cost basis. This is the original price or cost the taxpayer paid for the asset, plus any extras like fees.

Determine the asset’s adjusted cost basis. This is the cost basis of the asset that is adjusted to account for various events during the ownership of that asset — like zoning costs, investment tax credits, insurance reimbursements for casualty and theft losses, etc. For instance, when selling a home, the adjusted basis is generally the initial cost to purchase it plus the cost of any capital improvements made — less casualty loss amounts — and other decreases.

Calculate the capital gain or loss. If the asset's sale results in a capital gain, it triggers a depreciation recapture tax liability. If the asset is sold at a loss, depreciation recapture will not apply. There is a capital gain if the taxpayer sells the asset for more than the adjusted basis. If the asset is sold for less than the adjusted basis, it is a capital loss. Keep in mind that the IRS taxes capital gains depending on how long an asset was held — short term or long term. Generally, if an asset is held for more than one year, the capital gain or loss is long term. The capital gain or loss is considered short term if it is one year or less.

Determine depreciation recapture value. Subtract the adjusted cost basis from the initial cost basis to calculate the depreciation recapture value. The IRS will tax to recapture depreciation based on the resulting figure. Note — the IRS taxes long-term gains at the capital gains tax rate, between 0% and 20%. Short-term gains are taxed as ordinary income. For section 1250 real property, the “portion of any unrecaptured section 1250 gain from selling section 1250 real property is taxed at a maximum 25% rate,” according to the IRS.

What is an example of depreciation recapture?

Consider the following examples of section 1245 and section 1250 depreciation recapture to further explain.

Example: Section 1245 depreciation recapture

Business A purchased a company vehicle for $20,000 and held it for four years. The company has now sold the vehicle for $14,000. The total accumulated depreciation is $8,000. The adjusted basis is $12,000.

The $14,000 sell price minus the $12,000 adjusted basis equals a $2,000 gain. Next, compare the accumulated depreciation of $8,000 to the gain of $2,000. The depreciation recapture is the lesser of these two figures, which is $2,000. The depreciation recapture of $2,000 is taxed at ordinary rates.

Example: Section 1250 depreciation recapture

Ten years ago, business A purchased commercial rental property for $390,000. It is now selling the property for $500,000. Additional details that must be factored in include:

Tenant improvements totaled $15,000, and 100% bonus depreciation was taken.

Under the straight-line method, the accumulated depreciation of the property totaled $100,000.

Under the straight-line method, the accumulated depreciation of the $15,000 in tenant improvements was $10,000 — a difference of $5,000. The adjusted basis totaled $290,000.

Now that the rental property has sold for $500,000, let’s determine the depreciation recapture: 

The $500,000 sell price minus the $290,000 adjusted basis equals a $210,000 gain.

The difference between accelerated and straight-line depreciation — $5,000 — is the section 1250 recapture and is taxed at ordinary income rates.

The gain up to total accumulated depreciation, excluding the section 1250 recapture, is the unrecaptured section 1250 gain. In this example, $100,000 of the property and the remaining $10,000 of the tenant improvement equals $110,000 unrecaptured section 1250. The $110,000 unrecaptured section 1250 is taxed at a maximum 25% rate.

The capital gain is the remaining gain after Section 1250 recapture and unrecaptured Section 1250 gain. So, in this scenario, the long-term capital gains of $95,000 — $210,000 minus $5,000 minus $110,000 equals $95,000 — are taxable at the long-term capital gain rates. It is considered a long-term capital gain because the property was held for more than one year.

Do heirs pay depreciation recapture?

No. In real estate, heirs typically do not inherit the depreciation recapture or capital gains tax liabilities. When property is inherited, the basis for the property is “stepped up” to its fair market value (FMV) at the date of the previous owner's death. This eliminates any depreciation recapture tax liability and then becomes the new basis for future allowable depreciation and any potential recapture tax in the future.

To further explain, consider the following example.

If you inherit property valued at $400,000 at the time of inheritance, this is the new basis for determining depreciation and any future depreciation recapture tax. This situation is regardless of the initial purchase price of the property.

It should be noted that if an heir continues to use the property and later sells it, they may be subject to future recapture tax if they, as the property owners, have claimed allowable depreciation.

Can depreciation recapture be minimized or eliminated?

Yes. There are strategies to minimize or avoid depreciation recapture tax liabilities. One of the more common strategies to defer depreciation recapture tax liabilities is to perform a 1031 exchange. 

Under a 1031 exchange, an owner sells a property and uses the proceeds to acquire a like-kind property to defer capital gains tax. Doing so also enables them to defer depreciation recapture taxes. In some cases, the owner may leverage 1031 exchanges until they die and then leave the property to an heir. 

When looking to reduce the impacts of depreciation recapture, some taxpayers may want to consider other strategies, such as: 

• A Section 121 exclusion. This strategy can significantly reduce or eliminate depreciation recapture tax. If a rental property owner uses the rental as their primary residence and lives in the home for at least two years out of a five-year period before selling the property, they can qualify for the exemption. Under the exemption, single individuals can exclude from their income up to $250,000 of capital gains from the sale of the home or up to $500,000 for married couples filing jointly.
• Tax loss harvesting. Taxpayers with an investment that has lost value can sell it within the same tax year as they sell a profitable investment to lower their overall tax burden. This harvesting strategy lowers their overall capital gains in that tax year, reducing or even eliminating the amount of depreciation recuperation taxes to be paid.