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A Guide to Depreciation Recapture for Real Estate

Published
Jan 22, 2024
By
Alexa Joan Macaluso, CPA
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When organizations plan to sell assets, whether real property or personal property, they will often want to calculate the gain or loss in order to understand the tax impacts associated with the sale. It’s generally not as simple as just taking the sales price less original purchase price due to various factors such as depreciation previously taken on an asset as well as selling expenses.

The sale of an asset can trigger what is called depreciation recapture. Depreciation recapture is a tax provision that requires a taxpayer to increase the gain on a profitable sale of an asset for amounts the taxpayer previously reported depreciation deductions to offset taxable income. Understanding the impact that depreciation recapture may have on a business’ tax liability can support owners in navigating the sale of an asset.

What is Tax Depreciation?

Tax depreciation is a tax deduction permitted by the Internal Revenue Code (“IRC”) which represents a reasonable allowance for the exhaustion, wear and tear for property used in a trade or business, or for the production of income.

The IRS publishes specific depreciation schedules for different classes of assets. The schedules articulate to taxpayers what percentage of an asset’s value is authorized to be deducted each year and the number of years for which the deductions are authorized.

What is Depreciation Recapture?

Depreciation recapture is triggered by a gain on the sale of an asset where the adjusted basis of the asset is used to compute such gain. The adjusted basis of the asset is the original cost basis of such asset reduced by depreciation deductions previously allowed or allowable. The amount of the gain up to the amount of depreciation previously taken is considered the depreciation recapture on the sale.

Note that the IRC provides that if an asset should have been depreciated at a greater rate than what was reported by the taxpayer, the gain is still computed as if the allowable depreciation had been taken. Therefore, it’s important that depreciation is correctly computed and reported each year during the ownership of the asset.

Types of Assets and Recapture

Depreciable assets, and real property, used by a trade or business and held for more than one year are categorized as section 1231 property. Two types of section 1231 property are Section 1245 and Section 1250 assets. These two classifications are sections in the IRC that require recharacterization of gain as ordinary income when certain types of assets are being considered. 

Section 1245 assets generally include depreciable personal property whereas section 1250 assets generally include depreciable real property. The tax rate for the depreciation recapture is contingent upon whether an asset is a section 1245 or 1250 asset.

When section 1250 property is sold, gain up to the amount of depreciation claimed is generally taxed at a maximum rate of 25 percent. However, note that this 25 percent recapture is referred to as “Unrecaptured Section 1250 Gain." True section 1250 recapture would be taxed at ordinary income tax rates, however it’s not too common since it only applies when the depreciation taken on such property was in excess of straight-line depreciation. Such excess would be taxed at ordinary income tax rates, with the remaining straight-line depreciation at 25 percent. Since most depreciable real property is depreciated under the straight-line method, true section 1250 recapture generally does not apply. Some circumstances where it may apply is where accelerated and/or bonus depreciation property is taken on real property such as land improvements or qualified improvement property.

When section 1245 property is sold, any depreciation recapture is taxed at ordinary income tax rates. Important to note is that cost segregation studies often reclassify a portion of real estate acquisitions as section 1245 property. Thus, depreciation recapture is often a concern for property owners contemplating a cost segregation study.

Section 1245 Depreciation Recapture

Below are examples of depreciation recapture for sales of section 1245 assets:

  • Business truck purchased for $20,000 and held for 4 years.
  • Total accumulated depreciation $8,000
  • Adjusted basis is $12,000

Example #1 - Truck is sold for $14,000.

  1. The business realizes gain in the amount of $2,000 ($14,000-$12,000 = $2,000).
  2. The accumulated depreciation of $8,000 is compared to the gain of $2,000. The lesser of the two figures is the depreciation recapture.
  3. Hence, the depreciation recapture is $2,000 (smaller of $8,000 or $2,000) and is taxed at ordinary rates.

Example #2 - Truck is sold for $30,000.

  1. The business realizes gain in the amount of $18,000 ($30,000-$12,000 = $18,000).
  2. Compare the accumulated depreciation to the realized gain of $18,000. The lesser of the two figures is the depreciation recapture.
  3. Hence, the depreciation recapture is $8,000 (smaller of $8,000 or $18,000) and is taxed at ordinary rates.
  4. The remaining $10,000 of realized gain is taxed at capital gain rates.

The rationale behind this calculation: Taxpayers benefit from lower ordinary income over the previous years due to the annual depreciation expense taken. Therefore, in the year of the sale, if profitable, taxpayers recapture the depreciation taken according to the calculations above after considering the overall gain by comparing the sale price to the adjusted basis of the asset.

Note that there is no depreciation to recapture if a loss were realized on the sale of the truck. Also, scenario #2 is generally unlikely to occur however because it’s not common for personal property such as trucks to appreciate in value.

Section 1250 Recapture and Unrecaptured Section 1250 Gain on Residential Real Estate Property

In real estate property, as noted above, there are two kinds of depreciation recapture:

  • Section 1250 recapture is the gain to the extent of the excess of depreciation claimed over straight-line and is taxed at ordinary income rates.
  • Unrecaptured 1250 gain is the gain to the extent of straight-line depreciation taken and is taxed at a 25% maximum rate.
  • Any additional gain is generally taxed at long-term capital gain rates (subjection to certain Section 1231 ordinary loss recapture rules which are outside the scope of this article).

Below is an example of depreciation recapture for the sale of section 1250 assets:

  • Commercial rental property purchased for $390,000 and held for 10 years.
  • Tenant improvements were incurred in the amount of $15,000 and 100% bonus depreciation was taken.
  • Accumulated depreciation of the building under straight-line is $100,000.
  • Accumulated depreciation of the tenant improvement is the bonus depreciation of $15,000. If it were depreciated under straight-line, accumulated depreciation would be $10,000 which yields to a difference of $5,000.
  • Adjusted basis is $290,000 ($390,000+$15,000-$100,000-$15,000 = $290,000).

Example - Rental property is sold for $500,000.

  1. The business realizes gain in the amount of $210,000 ($500,000-$290,000 = $210,000).
  2. Section 1250 recapture is the $5,000 difference between accelerated depreciation and straight-line depreciation and is taxed at ordinary income rates.
  3. Unrecaptured section 1250 gain is the gain up to total accumulated depreciation, excluding the Section 1250 recapture. Hence, the amount is $110,000 ($100,000 of the building and remaining $10,000 of the tenant improvement) and is taxed at a 25 percent rate.
  4. The capital gain is the remaining gain after Section 1250 recapture and Unrecaptured Section 1250 gain. Because the property was held more than one year (and ignoring any Section 1231 ordinary loss recapture requirement for purposes of this example), long-term capital gains in the amount of $95,000 ($210,000-$5,000-$110,000 = $95,000) should be taxable at long-term capital gain rates.

Navigating Tax Implications

It’s important to consider, prior to purchasing an asset, how long such asset will remain with the business. Whether it’s a piece of machinery, a truck, or a building, it’s important to keep in mind the potential for depreciation recapture to impact tax liabilities in the future.

If you’re planning to acquire tangible depreciable assets (whether personal property or real property), consultation with a tax professional is recommended to obtain guidance on:

  • Asset categorization
  • Recovery period
  • Tax depreciation
  • Potential for gain or loss from a sale
  • Tax implications associated with a sale
  • Cost segregation study benefits

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