Depreciation Recapture

Depreciation recapture is the gain received from the sale of depreciable capital property that must be reported as income. Depreciation recapture is assessed when the sale price of an asset exceeds the tax basis or adjusted cost basis. The difference between these figures is thus "recaptured" by reporting it as income.

Depreciation recapture is reported on Internal Revenue Service (IRS) Form 4797.

Some assets tend to lose value over time. For tax purposes, the value that is lost on an asset is recognized as a depreciation expense for each year. Depreciation allows the owner of an asset or a business to divide the cost of an asset over a number of years, thereby reducing the adjusted cost basis of the asset. If the depreciated asset is disposed of or sold for a gain, the ordinary income tax rate will be applied on the amount of the recaptured depreciation expense.

Depreciation recapture is a tax provision that allows the IRS to collect taxes on any profitable sale of an asset that the taxpayer had used to offset his or her taxable income. Since depreciation of an asset can be used to deduct ordinary income, any gain from the disposal of the asset must be reported as ordinary income, rather than the more favorable capital gain. The IRS publishes specific depreciation schedules for different classes of assets. The schedules tell a taxpayer what percentage of an asset’s value may be deducted each year and the number of years for which the deductions may be taken.

The first step in evaluating depreciation recapture is to determine the cost basis of the asset. The original cost basis is the price that was paid to acquire the asset. The adjusted cost basis is the original cost basis minus any allowed or allowable depreciation expense incurred. For example, if business equipment was purchased for $10,000 and had a depreciation cost of $2,000 per year, its adjusted cost basis after four years would be $10,000 - ($2,000 x 4) = $2,000.

The depreciation would be recaptured if the equipment is sold for a gain. If the equipment is sold for $3,000, the business would have a taxable gain of $3,000 - $2,000 = $1,000. It is easy to think that a loss occurred from the sale since the asset was purchased for $10,000 and sold for only $3,000. However, gains and losses are realized from the adjusted cost basis, not the original cost basis.

The realized gain from an asset sale must be compared with the depreciation expense. The smaller of the two figures is considered by the IRS to be the depreciation recapture. In our example above, since the realized gain on the sale of the equipment is $1,000, and depreciation expense is $8,000, the depreciation recapture is, therefore, $1,000. This recaptured amount will be treated as ordinary income when taxes are filed for the year. There is no depreciation to recapture if a loss was realized on the sale of a depreciated asset.

Not all sales of assets are reported fully as ordinary income. For example, gain from the sale of residential rental property has a capital gain application to it. Part of the gain is taxed as a capital gain and might qualify for the maximum 20% rate on long-term gains, but the part that is related to depreciation is taxed at the ordinary tax rate and this can be significantly higher. The technical term for a gain related to depreciation on residential property is “unrecaptured section 1250 gain.”

For example, consider a rental property that was purchased for $350,000 and has an annual depreciation of $20,000. After 11 years, the owner decides to sell the property for $430,000. The adjusted cost basis then is $350,000 - ($20,000 x 11) = $130,000. The realized gain on the sale will be $430,000 - $130,000 = $300,000. Capital gain on the property can be calculated as $300,000 - ($20,000 x 11) = $80,000, and the depreciation recapture gain is $20,000 x 11 = $220,000.

Let’s assume a 15% capital gains tax and that the owner falls in the 28% income tax bracket for 2017. The total amount of tax that the taxpayer will owe on the sale of this rental property is (0.15 x $80,000) + (0.28 x $220,000) = $12,000 + $61,600 = $73,600. The depreciation recapture amount is, thus, $61,600.