What is depreciation recapture (plain English)
– Depreciation recapture is a tax rule that requires you to pay tax on the portion of a gain from selling a business or investment asset that represents prior depreciation deductions. In short: you reduced taxable income in past years by claiming depreciation; if you later sell the asset for more than its tax (book) value, the IRS wants some of those earlier tax benefits taxed now.
Key definitions
– Depreciation: an annual tax or accounting deduction that spreads an asset’s cost over its useful life because the asset loses value with use or time.
– Adjusted cost basis: original purchase price minus accumulated depreciation. This is the tax basis used to calculate gain or loss on sale.
– Section 1245 property: most tangible business equipment, machinery, and vehicles. Gains up to the amount of prior depreciation are “recaptured” and taxed as ordinary income.
– Section 1250 property: depreciable real property (buildings, structural components). Recapture treatment for real estate is different and generally limited (often called “unrecaptured Section 1250 gain”), taxed at a special maximum rate (commonly up to 25% for the recaptured portion).
– Form 4797: the IRS form used to report sales of business property, including depreciation recapture.
Why recapture exists (short)
– Depreciation reduces taxable income in the years you claimed it. If you later sell the asset for more than the adjusted basis, the IRS treats part of the sale gain as reversing those earlier deductions and taxes it at ordinary income rates (or a special rate for some real estate gains).
Step-by-step checklist to determine if you face depreciation recapture
1. Identify the asset class (Section 1245 vs Section 1250).
2. Gather cost information: original purchase price and total depreciation taken to date.
3. Compute adjusted cost basis = original cost − accumulated depreciation.
4. Calculate realized gain = sale price − adjusted cost basis.
5. Determine recapture amount:
– For Section 1245: recapture amount = lesser of accumulated depreciation or realized gain; that amount is taxed as ordinary income.
– For Section 1250 (real estate): only the part attributable to excess depreciation over straight-line is recaptured as ordinary income in some cases; otherwise you may have “unrecaptured Section 1250 gain” taxed at up to 25%.
6. Separate the gain into the recaptured portion (taxed at ordinary or special recapture rate) and any remaining gain (potentially taxed at capital gains rates).
7. Report the sale and recapture on IRS Form 4797 (and Schedule D or Form 8949 for capital gain portions, if appropriate).
8. Consider state tax rules and consult a tax professional before filing.
Worked numeric examples (simple, illustrative)
Example A — Equipment (Section 1245)
– Purchase price: $50,000
– Accumulated depreciation claimed: $25,000
– Adjusted cost basis = $50,000 − $25,000 = $25,000
– Sale price scenario 1: $30,000
– Realized gain = $30,000 − $25,000 = $5,000
– Recapture = lesser of accumulated depreciation ($25,000) and realized gain ($5,000) = $5,000
– Tax treatment: $5,000 taxed as ordinary income (report on Form 4797). No capital-gains portion.
– Sale price scenario 2: $60,000
– Realized gain = $60,000 − $25,000 = $35,000
– Recapture = lesser of $25,000 and $35,000 = $25,000 (taxed as ordinary income)
– Remaining gain = $35,000 − $25,000 = $10,000 (may be taxed as capital gain, subject to holding-period rules)
If you want to see how much tax that produces, pick your ordinary tax rate and capital gains rate and multiply each tax base by its rate. Example (illustrative only): if ordinary rate = 24% and capital gains rate = 15%, then taxes = (25,000 × 24%) + (10,000 × 15%) = 6,000 + 1,500 = 7,500.
Example B — Real estate (Section 1250, simplified)
– Purchase price: $200,000
– Straight-line depreciation taken: $40,000
– Adjusted basis = $160,000
– Sale price: $230,000
– Realized gain = $230,000 − $160,000 = $70,000
– The portion attributable to prior straight-line depreciation (here $40,000) is generally taxed under special rules for unrecaptured Section 1250 gain (capped at 25%), with the remainder potentially taxed at capital gains rates
Continuing Example B:
Finish the numeric tax calculation (assumptions)
– Assumptions: ordinary (ordinary income) tax rate = 24%; long-term capital gains rate = 15%; unrecaptured Section 1250 rate cap = 25%.
– Realized gain from sale = $70,000 (sale price $230,000 − adjusted basis $160,000).
– Portion attributable to prior straight‑line depreciation = $40,000. This portion is “unrecaptured Section 1250 gain” — taxable at a maximum 25% rate (it does not get the lower capital‑gains rate below 25% for that depreciation portion).
– Remaining gain = $70,000 − $40,000 = $30,000. That portion may qualify for the regular long‑term capital gains rate (here 15%).
Step-by-step math
1. Tax on unrecaptured Section 1250 portion: $40,000 × 25% = $10,000.
2. Tax on remaining capital gain: $30,000 × 15% = $4,500.
3. Total federal tax on the gain = $10,000 + $4,500 = $14,500.
Notes and assumptions about the example
– The 25% figure here is a statutory cap for unrecaptured Section 1250 gain; it’s not a flat “extra” tax above ordinary rates. If your ordinary tax rate exceeds 25%, only the depreciation portion is taxed at up to 25% (not at your full ordinary rate) for the unrecaptured portion.
– This example ignores state income tax, the 3.8% Net Investment Income Tax (if applicable), and any other surtaxes or credits that could change the final bill.
– If the property were Section 1245 property (typically depreciable personal property such as equipment), depreciation recapture up to the amount of prior depreciation is generally taxed as ordinary income — i.e., at your full ordinary income tax rate, not at the 25% cap.
Checklist: how to compute depreciation recapture for a sale
1. Confirm asset type: Section 1245 (personal/ordinary) vs. Section 1250 (real property). This determines tax character of recapture.
2. Determine original cost basis and accumulated depreciation.
3. Calculate adjusted basis = cost basis − accumulated depreciation.
4. Compute realized gain = sale proceeds − adjusted basis. If realized gain ≤ 0, there is no recapture