What Are the Rules for Additional Depreciation After 1975?

Prior to the establishment of the modern Modified Accelerated Cost Recovery System (MACRS), a different set of rules determined how depreciation was handled when real estate was sold. For property owners who placed buildings into service after December 31, 1975, but before the Accelerated Cost Recovery System (ACRS) was introduced in 1981, the tax implications upon sale can be complex.

The tax laws from that era focused on a concept called “additional depreciation” and its potential “recapture” as ordinary income. This meant that a portion of the gain from a sale, which might otherwise be taxed at lower capital gains rates, could be reclassified and taxed at higher ordinary income rates. Understanding these historical rules is necessary for determining the tax consequences of selling property that has been held for several decades.

Defining Additional Depreciation for Section 1250 Property

Two concepts are central to the recapture rules: Section 1250 property and additional depreciation. Section 1250 of the Internal Revenue Code pertains to depreciable real property, which includes buildings and their structural components. It is distinct from Section 1245 property, which covers tangible personal property. For the period after 1975, the characterization of a building as Section 1250 property was the starting point for determining how its sale would be taxed.

Additional depreciation is the excess of depreciation deductions you claimed over the deductions that would have been allowed under the straight-line method. The straight-line method allocates the cost of an asset evenly over its useful life, while accelerated depreciation methods allowed for larger deductions in the earlier years of an asset’s life. This difference between the accelerated amount taken and the straight-line amount is “additional depreciation.”

For example, imagine a taxpayer placed a commercial building in service and claimed $15,000 in depreciation using an accelerated method. If, for that same period, the depreciation calculated using the straight-line method would have been only $10,000, the additional depreciation is the $5,000 difference. This $5,000 amount becomes the target for potential recapture upon the sale of the property.

This calculation isolates the tax benefit from accelerated depreciation. The tax law recaptures this benefit by converting a portion of the capital gain on the sale into ordinary income. The amount recharacterized is tied to the additional depreciation claimed over the property’s holding period.

Recapture Rules for Nonresidential Real Property

For nonresidential real property, such as office buildings or warehouses, placed in service after 1975 and before 1981, the recapture rules depended on the holding period and the depreciation method used.

If the nonresidential property was sold after being held for one year or less, all depreciation claimed was subject to recapture as ordinary income, up to the amount of the total gain. In this scenario, the distinction between accelerated and straight-line depreciation was irrelevant. The entire amount of depreciation deductions taken was recaptured as ordinary income at the time of sale.

A different rule applied if the property was held for more than one year and an accelerated depreciation method had been used. In this case, only the “additional depreciation” was subject to recapture as ordinary income. The amount of gain equal to the additional depreciation was taxed at ordinary income rates, while any remaining gain was treated as a Section 1231 gain, which could receive more favorable capital gain treatment.

If the owner of a nonresidential property chose to use the straight-line method of depreciation from the outset, there was no additional depreciation to recapture. For these properties held more than one year, the entire gain on the sale would qualify as a Section 1231 gain. This incentivized using the straight-line method to ensure more favorable tax treatment upon sale.

Recapture Rules for Residential Rental Property

The tax treatment for the sale of residential rental property placed in service after 1975 but before 1981 was structured differently from that of nonresidential property. The rules were more favorable, but the use of an accelerated depreciation method was still the trigger for potential recapture of depreciation as ordinary income.

For residential rental property held for more than one year, any gain on the sale was subject to recapture based on the amount of additional depreciation claimed. The “applicable percentage” for this type of property was 100 percent of the additional depreciation. This meant that upon selling the property, the portion of the gain equal to the total additional depreciation claimed after December 31, 1975, would be treated as ordinary income.

The calculation is direct: determine the total gain on the sale and the total additional depreciation. The lesser of these two amounts is the amount recaptured as ordinary income. Any remaining gain would then be treated as a Section 1231 gain, potentially taxed at lower long-term capital gain rates.

Unlike the special provisions for low-income housing, there was no phase-out period for standard residential rental properties. The 100 percent applicable percentage for additional depreciation remained constant regardless of how long the property was held beyond one year.

Special Provisions for Low-Income Housing

The tax code provided more generous recapture rules for certain types of low-income housing projects to incentivize private investment in affordable housing. These provisions applied to specific properties, such as those with mortgages insured under National Housing Act Sections 221(d)(3) or 236, or other similar state and local programs. For these qualifying properties, the amount of additional depreciation subject to recapture could be reduced over time.

The main feature of these provisions was a phase-out of the recapture percentage based on the property’s holding period. For the first 100 full months (eight years and four months) the property was held, the applicable percentage for recapture was 100 percent of the additional depreciation. If the property were sold within this initial period, all additional depreciation would be recaptured as ordinary income.

After the initial 100-month period, the recapture percentage began to decrease. For each full month the property was held beyond 100 months, the applicable percentage was reduced by one percent. For example, if a qualifying low-income housing property was held for 120 full months (10 years), the recapture percentage would be reduced to 80 percent (100 percent minus 20 percent for the 20 months over 100).

This phase-out continued until the property had been held for a total of 200 months, which is equivalent to 16 years and 8 months. At that point, the applicable percentage would be reduced to zero. If a qualifying low-income housing project was sold after being held for at least 200 months, none of the additional depreciation was subject to recapture as ordinary income, and the entire gain could be treated as a Section 1231 gain.

Calculating and Reporting Recapture on Form 4797

When a piece of business property is sold, the transaction must be reported to the IRS on Form 4797, Sales of Business Property. This form is used to calculate both the total gain or loss from the sale and the specific portion of any gain that must be treated as ordinary income due to depreciation recapture.

The calculation of the recapture amount occurs in Part III of Form 4797, which is designed for gains from dispositions of depreciable property under Sections 1245 and 1250. The taxpayer must determine the gross sales price, the original cost basis, and the total depreciation claimed to arrive at the total gain on the sale. The applicable recapture percentage, which depends on the property type and holding period, is then applied to the additional depreciation amount.

The result of this calculation is the amount of the gain that must be reported as ordinary income. This ordinary income portion is carried from Part III to Part II of Form 4797 and is eventually transferred to the taxpayer’s main income tax return, such as Form 1040. Any gain remaining after subtracting the recaptured ordinary income is treated as a Section 1231 gain and reported in Part I of Form 4797, where it may be combined with other gains and losses to potentially receive capital gain treatment.