Depreciation recapture is a tax provision that allows the IRS to collect taxes on the profitable sale of a depreciated asset.
Depreciation recapture is the process used by the IRS to ‘recapture’ a portion of the value of an asset that has been depreciated.
Any gain made on the sale must be reported for tax purposes and when the sale price of an asset exceeds the tax basis or adjusted cost basis this will trigger a depreciation recapture assessment. The difference between the sale price and adjusted cost basis or tax basis is then liable to taxation and thus "recaptured".
Depreciation recapture is reported on Internal Revenue Service (IRS) Form 4797.
Real estate investors and companies alike can account for the wear and tear and gradual reduction in value of property, plant, and equipment through depreciation.
Depreciation divides the cost associated with the use of the asset over a number of years (called depreciation schedules) and allows companies to claim a tax deduction based on these depreciation schedules.
The IRS publishes specific depreciation schedules for different asset classes. For example, residential rental property can be depreciated over 27.5 years whilst commercial properties can be depreciated over 39 years.
Depreciation has two tax impacts. Firstly, it offsets the taxable income that you as an investor or company owe. And secondly, it reduces the cost basis of the property.
This second impact is especially important, for, as we mentioned earlier, depreciation recapture is calculated on the difference between the cost basis of the asset and the sale value.
When an asset is sold for a gain a depreciation recapture assessment is triggered and the total gain will be taxed. For non-real estate assets, this is taxed at your ordinary income tax rate. For real estate, however, this gain is taxed at a more favorable rate.
The depreciation recapture tax rate on real estate is capped at 25%.
Further reading and important terms
Whereas depreciation recapture on section 1245 capital property is taxed at your ordinary tax rate, depreciation recapture on real estate property, section 1250, is taxed at a different rate which is capped at 25%. Additionally, the part of the gain that goes beyond the original cost basis is taxed at the long-term capital gains tax rate.
It’s important to note that this can become more complicated if you use cost segregation and accelerated depreciation instead of straight-line depreciation.
In this example though we are going to specifically look at an example using straight-line depreciation over the life of the property.
You purchased a residential property in 2005 valued at $350,000, with a land value of $75,000.
Land is not depreciable, and so you have an original property cost basis of $275,000.
You can depreciate the property over a period of 27.5 years (the ‘useful life’ as deemed by the IRS). This gives you an annual depreciation amount of $10,000.
In 2020 you sell the property for $430,000.
As you’ve owned the property for 15 years, the adjusted cost basis of the property becomes
$275,000 - ($10,000 x 15) = $125,000.
You also realize $80,000 in capital gains. $430,000 - $350,000.
If we assume a 20% capital gains tax and a 25% depreciation recapture tax.
20% of $80,000 = $16,000 in capital gains tax.
25% of $125,000 = $32,500 in depreciation recapture.
The total tax owed in this example then would be $48,500.
Depreciation recapture is calculated by determining the difference between the adjusted cost basis of the property and the sale price of the asset.
The adjusted cost basis of an asset is calculated by subtracting the depreciated amount from the original sales value of the asset.
If, for example, the adjusted cost basis of an asset is $2,000 and the asset is sold for $3,000, there is a gain of $1,000 to be taxed. The rate it will be taxed depends on the taxpayer’s income tax rate and whether the asset is real estate.
For real estate, as we’ve established above this calculation is slightly different as you have to contend with capital gains which are taxed at a separate rate as well as land value.
Looking at the real estate example above you can see the original cost basis of the property (minus the value of the land which is non-depreciable) is $275,000, and the depreciation claimed is $150,000 over 15 years. Meaning the adjusted cost basis is $125,000.
Depreciation recapture for section 1245 property is categorized as regular income and subjected to your ordinary tax rates.
For real estate, the process becomes more intricate. The profit exceeding the initial cost basis is taxed as a capital gain, while the portion associated with depreciation is subject to the unrecaptured gains section 1250 tax rate, with a maximum limit of 25%.
Depreciation recapture can be quite costly when selling something like real estate. Other than selling the property for less, which isn’t a favorable option, ways around it could include using a 1031 exchange to defer realizing any gains on the property and the subsequent depreciation recapture. Even if you do use a 1031 exchange, when or if you do eventually cash out you will have to pay the relevant taxes at that point.
Depreciation recapture provides the IRS with a mechanism to collect taxes on the profitable sale of an asset that a taxpayer previously utilized to offset taxable income. During the ownership of the asset, the taxpayer is allowed to annually deduct its diminishing value to lower their owed income tax.
However, upon selling the asset, the IRS reclaims a portion of the depreciated amount and taxes any gains.
The calculation of depreciation recapture involves subtracting the adjusted cost basis, which is the original asset price minus any permitted or allowable depreciation expenses incurred, from the sale price.
This applies only when the asset is sold for a value exceeding its adjusted cost basis and incurs varying taxation based on the type of asset. For non-real estate property, depreciation recapture is taxed at the taxpayer's ordinary income tax rate. In contrast, depreciation recapture on gains related to real estate property is capped at a maximum rate of 25%.
Whether or not your accelerate depreciation on your property you will want to make sure you have the tools and processes in place to accurately track your depreciation deduction each year. Landlord Studio is a powerful industry specific rental property accounting software that allows landlords to easily stay on top of their finances, claim every possible deduction, and easily run accountant approved tax reports.