Depreciation Recapture: Definition, Calculation, and Examples
Depreciation recapture requires business owners to pay more tax on the gain realized from the sale of depreciable business property. Basically, gain up to the amount of previous depreciation deductions is tax as ordinary income, rather than as a capital gain (which is typically taxed at a lower rate). Depreciation recapture ensures that the tax benefits received from depreciation deductions are effectively "paid back" if the asset appreciates in value by the time of its sale.
Key Takeaways
- Depreciation recapture occurs when you sell business property for a gain after taking depreciation deductions. This tax rule requires you to report part of your gain as ordinary income to “recapture” some of the benefit you previously received from the deductions.
- The amount and type of depreciation recapture can vary depending on whether the property is classified under Section 1245 (personal property such as furniture and equipment) or Section 1250 (real property such as commercial buildings and structural components) of the tax code, and whether straight-line or accelerated depreciation was used.
- When selling business property, calculate any depreciation recapture and report it on IRS Form 4797. The ordinary income portion is eventually transferred to your Form 1040.
- You might be able to minimize the tax hit from depreciation recapture. Potential strategies include purchasing replacement property in a Section 1031 exchange, timing the sale of business property to when you’re in a lower tax bracket, and investing in a Qualified Opportunity Fund.
Depreciation recapture
If you’re a business owner, you’ve probably bought at least some property to use in your work. It could be something as modest as a computer and some office furniture, or as expensive as heavy machinery or a building.
From a tax perspective, you can gradually, or in some cases immediately, write off the cost of most types of business property with depreciation deductions. But those deductions come with a catch – you might have to pay a depreciation recapture tax when you get rid of the property.
Depreciation recapture is an important tax concept, because the extra tax will cut into your bottom line when you sell business property. Many business owners aren’t aware of or prepared for depreciation recapture, and they’re caught off guard by the higher-than-expected tax bill. To help avoid this, the following discussion provides an overview of the depreciation recapture rules.
The idea is to give you some basic information about depreciation recapture so that you can account for it before buying or selling depreciable property for your business. However, there are many special rules and exceptions that apply in certain circumstances. As a result, it’s wise to consult with a qualified tax professional before moving forward with the purchase or sale of business property.
What is depreciation?
To properly plan for depreciation recapture, it helps to first have a general understanding of depreciation and how it’s treated for tax purposes.
Depreciation is basically an accounting process used to deal with the fact that certain things you buy for your business – like buildings, computers, machines, or cars – don't last forever. Over time, they get old, wear out, or may not be as good as newer versions. As a result, from an accounting perspective, depreciation allows business owners to spread out the cost of these items over the years they’re used instead of just the year they’re bought.
From a tax standpoint, the federal income tax rules generally follow a similar approach. Instead of deducting the cost of newly acquired property right away as a business expense, you typically must deduct business property over time as a depreciation deduction. Each depreciation deduction lowers the tax owed for that particular tax year.
The IRS has special rules for calculating annual depreciation deductions. The rules dictate how much you can write off each year, depending on what you bought and how long it's expected to last. Some depreciation methods let you save more on your taxes in the first few years, while others spread the savings out evenly over time.
Depreciation also affects the property’s basis and the amount of tax you may owe when you sell the property. That’s because you must decrease the basis of business property by the amount of each depreciation deducted you claim, or could have claimed, on your tax returns. In addition, a lower basis means you’re likely to have more taxable gain when the property is sold, since gain is generally equal to the sales price minus the property’s adjusted basis.
What is depreciation recapture?
Now let’s get into the nitty-gritty of depreciation recapture. If you sell or otherwise dispose of depreciated business property for a gain, depreciation recapture permits the IRS to take back or “recapture” some of the tax benefits you received over the years through depreciation deductions. You also have to recapture a Section 179 deduction if the percentage of business use drops to 50% or less for any year during the property's recovery period.
This is done by treating a portion of the gain as ordinary income and taxing it using the ordinary income tax rates, rather than treating it as capital gain that’s subject to the lower long-term capital gains tax rates under Section 1231 of the tax code. The idea is to prevent two tax breaks – depreciation deductions and lower tax rates – on the same property.
After identifying any gain that’s treated as ordinary income, the remaining gain, if any, is generally treated as long-term capital gain under Section 1231. However, any non-recaptured Section 1231 loss from the previous five years is treated as ordinary income.
The amount of gain considered ordinary income depends on the type of depreciated property – generally personal property vs. real property. The capital gains tax rate applied to any remaining gain also depends on the type of property involved.
How to calculate depreciation recapture
How much depreciation is recaptured and treated as ordinary income depends on whether the property you sell is “Section 1245 property” or “Section 1250 property.” The names come from the tax code sections that establish the recapture rules for each type of property. The taxation of unrecaptured gain is also based on whether you’re dealing with Section 1245 or Section 1250 property.
Generally speaking, Section 1245 property is depreciable personal property used in your business. This includes intangible personal property, such as patents, copyrights, and other intellectual property. Certain types of real property can be treated as Section 1245 property (for example, a research facility, except buildings and their structural components, used as an integral part of manufacturing), but we’ll focus on personal property for purposes of this discussion.
Depreciable real property used in your business is typically considered Section 1250 property. However, real property can’t be treated as Section 1250 property if it was previously treated as Section 1245 property. Likewise, if you change the use of Section 1250 property so that it becomes Section 1245 property, you can’t ever treat it as Section 1250 property again. Also, land isn’t depreciable property, so it can’t be Section 1250 property.
With a general understanding of Section 1245 and Section 1250 property, let’s now take a look at how depreciation recapture works for both types of property.
Depreciation recapture for Section 1245 property
If you have a gain from the sale or other disposition of Section 1245 property, all depreciation deductions previously taken for the property, or allowed if not actually taken, are recaptured and taxed as ordinary income. However, the amount considered ordinary income can’t exceed the total amount of gain from the sale or disposition.
Any remaining gain after the depreciation recapture is generally treated as long-term capital gain and taxed at the lower rates under Section 1231 of the tax code.
To illustrate how the Section 1245 recapture rules work, take a look at the following hypothetical situations:
Gain is greater than depreciation deductions. You bought a piece of business equipment (personal property) five years ago for $20,000. Since then, you claimed depreciation deductions for the property totaling $4,500. You then sell the equipment for $21,000. The property’s adjusted basis when you sell it is $15,500 ($20,000 - $4,500 = $15,500). That means you have $5,500 of gain ($21,000 - $15,500 = $5,500). You have no other gain or loss from the sale of business property.
Since the amount of gain exceeds the depreciation deductions, only $4,500 of the gain is treated as ordinary income and taxed at the ordinary income tax rates. The remaining $1,000 of gain ($5,500 - $4,500 = $1,000) is treated as capital gain and taxed at the long-term capital gains tax rates, which is up to 20%.
Gain is less than depreciation deductions. You bought a piece of business equipment (personal property) five years ago for $20,000. Since then, you claimed depreciation deductions for the property totaling $4,500. You then sell the equipment for $17,000. The property’s adjusted basis when you sell it is $15,500 ($20,000 - $4,500 = $15,500). That means you have $1,500 of gain ($17,000 - $15,500 = $1,500). You have no other gain or loss from the sale of business property.
Since the amount of gain is less than the depreciation deductions, the entire $1,500 of gain is treated as ordinary income and taxed at the ordinary income tax rates.
Depreciation recapture for Section 1250 property
Gain from the sale or other disposition of Section 1250 property is taxed as ordinary income to the extent there was “additional depreciation” allowed, or allowable, on the property. However, the amount taxed as ordinary income can’t be more than your total gain on the property.
If you held the property for one year or less, all the depreciation is additional depreciation. In that case, all your depreciation deductions are recaptured and treated as ordinary income, up to the amount of gain.
On the other hand, if you held Section 1250 property for more than one year, your additional depreciation is equal to the actual depreciation deductions claimed that exceed the depreciation allowed using the straight-line method of depreciation. That means you won’t have additional depreciation, and no gain will be treated as ordinary income, if you calculated depreciation using the straight-line method (e.g., for nonresidential real property and residential rental property placed in service after 1986).
TurboTax Tip:
Section 1250 property placed in service after 1986 is likely to be depreciated using the straight-line method under the Modified Accelerated Cost Recovery System (MACRS). As a result, it’s rare to have gain from the sale of Section 1250 treated as ordinary income these days.
As for any remaining gain, it’s treated as capital gain, but all or some of it can nevertheless be taxed at the ordinary income tax rates – up to a maximum of 25%. This portion of the gain is referred to as “unrecaptured Section 1250 gain,” and it’s only allowed up to the amount of depreciation claimed for the property. Any gain that exceeds the amount of depreciation claimed is taxed as long-term capital gain under Section 1231.
Here are a couple of examples of how the Section 1250 recapture rules are applied for property held for more than one year and depreciated using the straight-line method (which is the most common situation):
Gain is greater than depreciation deductions. You bought an office building five years ago for $2 million. Since then, you claimed depreciation deductions for the property totaling $256,000 using the straight-line method. You then sell the building for $2.1 million. The property’s adjusted basis when you sell it is $1.744 million ($2,000,000 - $256,000 = $1,744,000). That means you have $356,000 of gain ($2,100,000 - $1,744,000 = $356,000). You have no other gain or loss from the sale of business property.
Since the amount of gain exceeds the depreciation deductions, only $256,000 of the gain is treated as capital gain but taxed at the ordinary income tax rates up to a maximum of 25%. The remaining $100,000 of gain ($356,000 - $256,000 = $100,000) is treated as capital gain and taxed at the long-term capital gains tax rates (i.e., up to 20%).
Gain is less than depreciation deductions. You bought an office building five years ago for $2 million. Since then, you claimed depreciation deductions for the property totaling $256,000 using the straight-line method. You then sell the building for $1.9 million. The property’s adjusted basis when you sell it is $1.744 million ($2,000,000 - $256,000 = $1,744,000). That means you have $156,000 of gain ($1,900,000 - $1,744,000 = $156,000). You have no other gain or loss from the sale of business property.
Since the amount of gain is less than the depreciation deductions, the entire $156,000 of gain is treated as capital gain but taxed at the ordinary income tax rates up to a maximum of 25%.
How to report depreciation recapture on your tax return
The first step in reporting depreciation recapture on your federal tax return is to complete Form 4797, which is used to report the sale of property used in a trade or business. Depreciation recapture for Section 1245 property and Section 1250 property is calculated in Part III of the form. If you took a Section 179 expense deduction and the business use of the property decreased to 50% or less during the year, complete Part IV to figure the recapture amount.
Once you have calculated your depreciation recapture on Form 4797, the recaptured depreciation treated as ordinary income is transferred to Schedule 1 of Form 1040 and combined with your other income. The total amount of additional income reported on Schedule 1 is then reported on your Form 1040 and included in your taxable income.
If you also have capital gains or losses from the sale of your business property, you may also need to fill out Schedule D of Form 1040. For example, the part of any gain that’s not recaptured as ordinary income would be reported on Schedule D as a capital gain.
When you’re finished, you’ll need to attach Form 4797 and Schedule D, if required, to your Form 1040 or other appropriate tax return form.
How to avoid depreciation recapture
If you sell business property, depreciation recapture taxes will reduce the profitability of the sale. As a result, business owners ought to consider ways to avoid, mitigate, or delay depreciation recapture when possible.
Here are a few strategies that might work for you:
Complete a 1031 exchange. One of the most popular ways to defer depreciation recapture is to complete a 1031 exchange, also known as a “like-kind exchange”. This allows the seller to defer the recognition of capital gains and depreciation recapture by using the proceeds to purchase a replacement property that is "like-kind." However, it's important to note that personal property is no longer eligible for 1031 exchanges after the Tax Cuts and Jobs Act – only real property, such as buildings, qualifies.
Sell business property when you’re in a lower tax bracket. If your overall income is expected to be significantly lower in the future, wait to sell your business property (if you can) until then. That way, you might be in a lower tax bracket, which means you’ll owe less in tax on the gain treated as ordinary income. You might even be able to lower the tax on any profits treated as longer-term capital gain. As with the ordinary income tax rates, the long-term capital gain tax rates are also based in part on your taxable income.
Sell business property and invest proceeds in a qualified opportunity fund. You can defer capital gains tax on the sale of business or personal property if you invest the proceeds in a qualified opportunity fund (QOF). The QOF will then invest money in economically distressed communities. However, you might also be able to eliminate depreciation recapture if you hold your investment for 10 years and certain other requirements are met. Unfortunately, investing in a QOF isn’t an option for everyone, since a very high minimum investment is typically required.
Place business property in a charitable remainder trust. If you put business property into a charitable remainder trust, the trust can sell the property tax-free – including no depreciation recapture – and provide you with a stream of income for a period of time.
Hold business property until you die. If you hold onto business property until you die, the basis of the property gets “stepped up” to the fair market value at the time of your death. As a result, the reduction in the property’s basis from previous depreciation deductions is essentially eliminated. Your heirs can then sell the property without having to pay depreciation recapture or capital gains tax based on the original purchase price.
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