When Is Gain Subject to Recapture as Ordinary Income?

When selling a depreciated asset, the IRS may require part of the gain to be taxed as ordinary income rather than at lower capital gains rates. This process, known as depreciation recapture, prevents taxpayers from benefiting twice—first by deducting depreciation and then by receiving favorable tax treatment on the sale.

Understanding when this rule applies is important for businesses, investors, and property owners looking to manage tax liabilities effectively.

When Is Gain Recaptured as Ordinary Income

Depreciation recapture applies when an asset is sold for more than its adjusted basis. The IRS requires that the portion of the gain attributable to prior depreciation be taxed at ordinary income rates instead of the lower capital gains rate. This ensures that taxpayers do not receive both depreciation deductions and preferential tax treatment on the sale.

The extent of recapture depends on the asset type and its use. Business property, rental real estate, and equipment commonly trigger recapture. Fully depreciated assets are particularly affected, as any sale price above the adjusted basis may be subject to recapture.

The depreciation method used also influences recapture. Accelerated depreciation methods, such as those under the Modified Accelerated Cost Recovery System (MACRS), often lead to higher recapture amounts because they allow for larger deductions in earlier years. Straight-line depreciation, which spreads deductions evenly over time, generally results in a lower recapture amount.

Common Asset Classes That Trigger Recapture

Depreciation recapture rules vary based on asset classification under the Internal Revenue Code. The most common categories include Section 1245 property, which covers personal property like machinery and equipment, and Section 1250 property, which applies to depreciable real estate. Partnership interests can also trigger recapture when certain assets are sold within a partnership structure.

Section 1245

Section 1245 applies to depreciable personal property, such as machinery, vehicles, furniture, and certain leasehold improvements. When these assets are sold for more than their adjusted basis, all prior depreciation deductions must be recaptured as ordinary income, up to the total amount of depreciation claimed.

For example, if a business purchases equipment for $50,000, claims $30,000 in depreciation, and later sells the equipment for $40,000, the $30,000 of prior depreciation is taxed as ordinary income, while the remaining $10,000 gain may qualify for capital gains treatment.

Businesses using accelerated depreciation methods, such as MACRS, often face higher recapture amounts. Unlike real estate, which has different recapture rules under Section 1250, Section 1245 property does not benefit from lower capital gains tax rates on the recaptured portion. Instead, the entire recaptured amount is taxed at the seller’s ordinary income tax rate, which can be as high as 37% for individuals in the highest tax bracket as of 2024.

Section 1250

Section 1250 governs the recapture of depreciation on real property, such as commercial buildings and rental properties. Unlike Section 1245, which requires full recapture of all depreciation deductions, Section 1250 only recaptures depreciation that exceeds what would have been allowed under the straight-line method. This primarily affects properties that were depreciated using accelerated methods before the Tax Reform Act of 1986, which mandated straight-line depreciation for most real estate.

For properties placed in service after 1986, depreciation recapture under Section 1250 is limited. Instead of being taxed entirely as ordinary income, the recaptured amount is subject to a special tax rate of up to 25%, known as the “unrecaptured Section 1250 gain.”

For example, if a rental property was purchased for $500,000 and depreciated by $150,000, then later sold for $600,000, the $150,000 of prior depreciation would be taxed at the 25% rate, while the remaining $100,000 gain would be subject to capital gains tax rates, which range from 0% to 20% depending on the taxpayer’s income level.

If a property is sold at a loss, no recapture occurs. Additionally, if the property is exchanged in a like-kind exchange under Section 1031, the recapture may be deferred until the replacement property is sold.

Partnership Interests

When a partner sells or transfers an interest in a partnership, depreciation recapture can be triggered if the partnership holds depreciable assets. Under Section 751, the IRS treats a portion of the gain from the sale of a partnership interest as ordinary income to the extent that it represents the partner’s share of unrealized depreciation recapture on Section 1245 or Section 1250 property.

For example, if a partner owns a 25% stake in a business that holds $1 million in depreciated equipment and sells their interest for a gain, the IRS will require that the portion of the gain attributable to the equipment’s prior depreciation be taxed as ordinary income. The remaining gain, if any, may qualify for capital gains treatment.

Partnerships that allocate depreciation deductions to partners over time must track these amounts for recapture purposes. If a partnership distributes depreciated assets to a partner instead of selling them, the partner may still be subject to recapture when they later sell the asset. Investors in real estate partnerships, private equity funds, and other business ventures structured as partnerships should account for recapture to avoid unexpected tax liabilities.

How to Calculate the Recaptured Amount

To determine the recaptured amount, taxpayers must identify how much depreciation was claimed on the asset. Since depreciation reduces the asset’s adjusted basis, the difference between the sale price and the adjusted basis represents the total gain. However, only the portion corresponding to prior depreciation deductions is subject to recapture.

For example, if a business purchased equipment for $80,000 and depreciated it by $50,000, then later sold it for $70,000, the adjusted basis is $30,000. The total gain on the sale is $40,000. Since $50,000 of depreciation was taken, the recapture amount is capped at this figure. This means $40,000 of the gain is taxed as ordinary income. If the sale price had been higher, any gain beyond the depreciation amount would be eligible for capital gains treatment.

If the sale price is below the adjusted basis, no recapture occurs because there is no gain attributable to depreciation. Losses on depreciated assets may be deductible under different tax provisions but do not result in ordinary income recapture.

Assets subject to bonus depreciation or Section 179 expensing follow the same recapture principle but may result in a larger amount being taxed as ordinary income. These accelerated depreciation methods allow businesses to deduct more of the asset’s cost upfront, increasing the potential recapture upon sale. For example, if a company used 100% bonus depreciation on a $100,000 asset, the entire $100,000 would be subject to recapture if the asset is later sold for more than its adjusted basis.

Tax Reporting Considerations

Proper tax reporting of depreciation recapture is necessary to avoid penalties and ensure compliance with IRS regulations. When filing a tax return, the recaptured portion of the gain must be reported as ordinary income on Form 4797, Sales of Business Property. This form distinguishes between gains that qualify for capital gains treatment and those subject to recapture, ensuring the correct tax rate is applied. For individuals, this income flows to Schedule D and ultimately Form 1040, while corporations report it directly on their tax return.

Taxpayers should also consider the impact of recapture on estimated tax payments. Since recaptured depreciation is taxed at higher ordinary income rates, it can significantly increase tax liability, potentially triggering underpayment penalties if estimated payments are insufficient. Businesses and investors selling depreciated assets should adjust their estimated payments or withholdings accordingly.

State tax treatment of depreciation recapture varies. Some states conform to federal rules, while others impose different tax rates or disallow certain depreciation deductions, affecting the overall tax burden. Taxpayers operating in multiple states should assess how each jurisdiction treats recaptured income to ensure compliance and optimize tax planning strategies.