Depreciation Recapture
What Is Depreciation Recapture?
Depreciation recapture is the gain realized by the sale of
depreciable capital property that must be reported as ordinary income for tax
purposes. Depreciation recapture is assessed when the sale price of an asset
exceeds the tax basis or adjusted cost basis. The difference between these
figures is thus "recaptured" by reporting it as ordinary income.
Depreciation recapture is reported on Internal Revenue Service (IRS) Form
4797.
KEY TAKEAWAYS
Depreciation recapture is a tax provision that allows the IRS to collect
taxes on any profitable sale of an asset that the taxpayer had used to
previously offset taxable income.
Depreciation recapture on non-real estate property is taxed at the
taxpayer's ordinary income tax rate, rather than the more favorable capital
gains tax rate.
Depreciation recaptures on gains specific to real estate property are
capped at a maximum of 25% for 2019.
To calculate the amount of depreciation recapture, the adjusted cost basis
of the asset must be compared to the sale price of the asset.
Understanding Depreciation Recapture
Companies account for wear and tear on property, plant, and
equipment through depreciation. Depreciation divides the cost associated with
the use of an asset over a number of years. The IRS publishes specific
depreciation schedules for different classes of assets. The schedules tell a
taxpayer what percentage of an asset’s value may be deducted each year and
the number of years for which the deductions may be taken.
For tax purposes, annual depreciation expense lowers the ordinary income that a
company or individual pays each year and reduces the adjusted cost basis of the
asset. If the depreciated asset is disposed of or sold for a gain, the ordinary
income tax rate will be applied to the amount of the depreciation expense
previously taken on the asset.
Depreciation recapture is a tax provision that allows the IRS to collect taxes on
any profitable sale of an asset that the taxpayer had used to previously offset his
or her taxable income. Since depreciation of an asset can be used to deduct
ordinary income, any gain from the disposal of the asset must be reported and
taxed as ordinary income, rather than the more favorable capital gains tax rate.
Depreciable capital assets held by a business for over a year are considered to
be Section 1231 property, as defined in section 1231 of the IRS Code. Section
1231 is an umbrella for both Section 1245 property and Section 1250 property.
Section 1245 refers to capital property that is not a building or structural
component. Section 1250 refers to real estate property, such as buildings and
land. The tax rate for the depreciation recapture will depend on whether an asset
is a section 1245 or 1250 asset.
Examples of Depreciation Recapture
Section 1245 Depreciation Recapture
The first step in evaluating depreciation recapture is to determine the cost
basis of the asset. The original cost basis is the price that was paid to acquire the
asset. The adjusted cost basis is the original cost basis minus any allowed or
allowable depreciation expense incurred. For example, if business equipment
was purchased for $10,000 and had a depreciation expense of $2,000 per year,
its adjusted cost basis after four years would be $10,000 - ($2,000 x 4) = $2,000.
For income tax purposes, the depreciation would be recaptured if the equipment
is sold for a gain. If the equipment is sold for $3,000, the business would have a
taxable gain of $3,000 - $2,000 = $1,000. It is easy to think that a loss occurred
from the sale since the asset was purchased for $10,000 and sold for only
$3,000. However, gains and losses are realized from the adjusted cost basis, not
the original cost basis. The reasoning for this method is because the taxpayer
has benefited from lower ordinary income over the previous years due to annual
depreciation expense.
The realized gain from an asset sale must be compared with the accumulated
depreciation. The smaller of the two figures is considered to be the depreciation
recapture. In our example above, since the realized gain on the sale of the
equipment is $1,000, and accumulated depreciation taken through year four is
$8,000, the depreciation recapture is thus $1,000. This recaptured amount will be
treated as ordinary income when taxes are filed for the year.
Instead, assume the equipment in the example above was sold for $12,000. In
that case, the entire accumulated depreciation of $8,000 is treated as ordinary
income for depreciation recapture purposes. The additional $2,000 is treated as
a capital gain, and it is taxed at the favorable capital gains rate. There is no
depreciation to recapture if a loss was realized on the sale of a depreciated
asset.
Unrecaptured Section 1250 Gain
Depreciation recapture on real estate property is not taxed at the ordinary income
rate as long as straight-line depreciation was used over the life of the property.
Any accelerated depreciation previously taken is still taxed at the ordinary
income tax rate during recapture. However, this is a rare occurrence because the
IRS has mandated all post-1986 real estate be depreciated using the straight-line
method.
Part of the gain beyond the original cost basis is taxed as a capital gain and
qualifies for the favorable tax rate on long-term gains, but the part that is related
to depreciation is taxed at the unrecaptured gains section 1250 tax rate specific
only to gains on real estate property. The unrecaptured section 1250 tax rate is
capped at 25% for 2019.
For example, consider a rental property that was purchased for $275,000 and
has an annual depreciation of $10,000 ($275,000 / 27.5 years allowed by IRS for
rental property). After 11 years, the owner decides to sell the property for
$430,000. The adjusted cost basis then is $275,000 - ($10,000 x 11) = $165,000.
The realized gain on the sale will be $430,000 - $165,000 = $265,000. The
unrecaptured section 1250 gain can be calculated as $10,000 x 11 = $110,000,
and the capital gain on the property is $265,000 - ($10,000 x 11) = $155,000.
Let’s assume a 15% capital gains tax and that the owner falls in the 32% income
tax bracket for 2019. Unrecaptured section 1250 gains are limited to 25% for
2019. The total amount of tax that the taxpayer will owe on the sale of this rental
property is (0.15 x $155,000) + (0.25 x $110,000) = $23,250 + $27,500 =
$50,750. The depreciation recapture amount is, thus, $27,500.
