Depreciation Recapture

Depreciation Recapture

Depreciation recapture is the tax the IRS collects when you sell a business or investment asset for more than its adjusted (depreciated) basis. If you previously reduced taxable income by claiming depreciation deductions, and the asset later sells for more than its depreciated value, the IRS “recaptures” some or all of those prior tax benefits.

How depreciation works

Businesses deduct the cost of wear-and-tear assets over time through depreciation rather than expensing the full purchase price in one year. Depreciation matches expense to the period the asset helps generate income and reduces taxable income while the asset is owned.

When an asset is sold, its adjusted cost basis equals the original cost minus accumulated depreciation. If the sale price exceeds that adjusted basis, the excess may be subject to depreciation recapture.

IRS categories and recapture rules

The tax code treats assets differently for recapture:

• Section 1245: Most business equipment, machinery, and vehicles. Recapture is taxed as ordinary income up to the total depreciation taken. Any gain beyond that amount may be taxed at capital gains rates.
• Section 1250: Real estate (e.g., rental properties). Recapture on depreciation is generally capped at a maximum 25% rate; gains above the original purchase price can qualify for long-term capital gains rates. Real property depreciation is typically taken using straight-line depreciation.

Section 1245 (equipment and machinery)

• Depreciation recapture is taxed as ordinary income (potentially up to your top marginal rate) for the amount of depreciation you deducted.
• Any additional gain beyond the total depreciation claimed may be taxed as capital gain.

Example:
– Purchase price: $50,000
– Depreciation taken over five years: $25,000
– Adjusted basis: $25,000
– Sale price: $30,000 → $5,000 gain taxed as ordinary income
– Sale price: $60,000 → First $25,000 of gain taxed as ordinary income (recapture); remaining $10,000 taxed at capital gains rates

Section 1250 (real estate)

• Depreciation recapture on real property is capped at a maximum 25% tax rate on the portion of gain equal to prior depreciation.
• Profit above the original purchase price is taxed at long-term capital gains rates (often lower than ordinary income rates).
• Residential rental property is generally depreciated over 27.5 years using straight-line depreciation.

Real estate example:
– Purchase price: $500,000
– Depreciation over 10 years (approx.): $181,820
– Adjusted basis: $318,180
– Sale price: $700,000
– Depreciation recapture tax: $181,820 taxed at up to 25% → $45,455
– Capital gains tax: $200,000 (sale price − original price) taxed at 15% (typical rate) → $30,000
– Total tax on gains in this example: $75,455

How it’s reported

Depreciation recapture and sales of business property are reported on IRS Form 4797. Be sure your records document original cost, accumulated depreciation, and sale proceeds to determine adjusted basis and recapture amounts accurately.

Key takeaways

• Depreciation recapture reclaims tax benefits you previously received from depreciation when an asset is sold for more than its depreciated value.
• Equipment and machinery (Section 1245) generally trigger recapture taxed as ordinary income up to the amount of depreciation claimed.
• Real estate (Section 1250) has a favorable recapture cap (maximum 25% on the depreciated portion); gains above the original purchase price can receive long-term capital gains treatment.
• Keep detailed depreciation records and consider potential recapture tax when timing or pricing the sale of depreciated assets.

Bottom line

Depreciation reduces taxes while you own an asset, but selling the asset for more than its depreciated value can reverse some of that benefit through recapture. Understand your adjusted basis, the applicable recapture rules for the asset type, and how the recapture will affect your overall tax outcome before selling.