What Does It Mean to Recover Depreciation for Taxes?

When a business invests in an asset, it can deduct a portion of the asset’s cost over several years through a deduction known as depreciation. While these deductions reduce taxable income, they also create a future tax liability that emerges when the asset is sold. The process of settling this liability is referred to as recovering depreciation, which can result in a higher tax bill upon the sale of business property.

Understanding Depreciation Recapture

Depreciation is an annual tax deduction that allows a business to account for the wear and tear of its assets, such as equipment or buildings. As depreciation is claimed each year, the asset’s value on the company’s books, known as its basis, is reduced. The adjusted basis is calculated by taking the asset’s original purchase price and subtracting the total accumulated depreciation claimed.

When that asset is sold, the total gain is the difference between the sale price and this adjusted basis. A portion of this gain may be subject to depreciation recapture. This is the mechanism the Internal Revenue Service (IRS) uses to reclaim the tax benefits a taxpayer received from depreciation deductions. The portion of the gain attributable to the depreciation is taxed, but the rate depends on the type of property sold.

The IRS requires taxpayers to calculate recapture based on the depreciation that was “allowed or allowable” under tax law. This means the calculation must be made even if the taxpayer did not claim the deduction on their tax returns. Proper record-keeping of both the original cost and all depreciation taken is fundamental to correctly calculating the tax consequences of a sale.

Recapture Rules for Personal Property

For tax purposes, personal property includes tangible assets other than real estate. This category, referred to as Section 1245 property by the IRS, covers items like machinery, equipment, vehicles, and furniture. When Section 1245 property is sold at a gain, the recapture rules reclassify a portion of the gain from a capital gain to ordinary income.

Any gain on the sale, up to the total amount of depreciation previously claimed, is taxed at the seller’s regular ordinary income tax rate, which can be as high as 37%. Any portion of the gain that exceeds the original cost of the asset is then treated as a capital gain under Section 1231. This means a single sale can generate both ordinary income and capital gain.

For example, a business buys equipment for $10,000. It claims $6,000 in depreciation, reducing the adjusted basis to $4,000. The business then sells the equipment for $12,000, resulting in a total gain of $8,000. The first $6,000 of the gain, equal to the depreciation taken, is recaptured and taxed as ordinary income.

The remaining $2,000 of the gain is the amount the asset sold for above its original cost. This portion is not subject to recapture and is treated as a Section 1231 gain, which is taxed at the more favorable long-term capital gains rates.

Recapture Rules for Real Property

The regulations for real property, defined by the IRS as Section 1250 property, are different from those for personal property. Real property includes assets like commercial buildings and warehouses. These rules are often more favorable, as they do not convert the gain attributable to depreciation into ordinary income if a specific depreciation method was used.

For most real property placed in service after 1986, depreciation is calculated using the straight-line method. When this property is sold at a gain, the portion of the gain related to this depreciation is not recaptured as ordinary income. Instead, it is classified as “unrecaptured Section 1250 gain,” which is subject to a maximum capital gains tax rate of 25%.

If an accelerated depreciation method was used, which allows for larger deductions in the early years, the rules are more complex. In that case, the “additional depreciation” (the amount beyond what the straight-line method would have allowed) is subject to recapture as ordinary income. However, since straight-line depreciation is mandatory for most real property acquired today, this situation is less common.

Imagine an investor buys a rental property for $300,000 and claims $50,000 in straight-line depreciation, reducing the basis to $250,000. They later sell it for $350,000, for a total gain of $100,000. The $50,000 of gain from depreciation is an unrecaptured Section 1250 gain, taxed at a maximum of 25%. The remaining $50,000 is a standard long-term capital gain, taxed at the applicable 0%, 15%, or 20% rate.

How to Calculate and Report Recaptured Depreciation

Taxpayers must use Form 4797, Sales of Business Property, to report the disposition of assets used in a trade or business. This form is the central document for determining the character of the gain or loss from the sale of depreciable property.

The form is structured to handle the different recapture rules. Gains from personal property (Section 1245 assets) are calculated in Part III, where the form guides the taxpayer to determine how much of the gain is ordinary income due to recapture. This ordinary income amount is then transferred to Part II and carried to the taxpayer’s main tax return, such as Form 1040.

Any gain in excess of the recaptured amount is a Section 1231 gain, which is also determined in Part III before flowing to other parts of the tax return.

The reporting for real property (Section 1250 assets) also begins in Part III of Form 4797. The portion of the gain identified as unrecaptured Section 1250 gain is calculated and then carried to Schedule D (Form 1040), Capital Gains and Losses. On Schedule D, this gain is separated so it can be subjected to the specific 25% maximum tax rate.