Learn 100% online from anywhere in the world. Enroll today!

Depreciation Recapture

A procedure by the Internal Revenue Service (IRS) in the U.S. to collect taxes on the sale of depreciated property

What is Depreciation Recapture?

Depreciation recapture is a procedure by the Internal Revenue Service (IRS) in the U.S. to collect taxes on the sale of property that’s been depreciated.

 

Depreciation Recapture

 

The property must have been previously used to offset the owner’s ordinary income due to depreciation. Therefore, when you file taxes, the gain from the sale of the property must be reported as ordinary income, not capital gain.

When an asset depreciates, it is when it loses value over time. The sale of a depreciated asset can be reported as ordinary income if the sale price is more than its adjusted cost basis. The difference between the figures must be reported as part of the individual’s ordinary income when they file their taxes.

 

What is Adjusted Cost Basis?

 

Adjusted Cost Basis = Asset’s Purchase Price + Improvements – Depreciation Deductions

 

According to IRC Section 1016, the adjusted cost basis is the net cost of an asset after adjusting for increases in improvements to the property or decreases in depreciation deductions allowed for the property.

Therefore, if the purchase price of the asset is $50,000, and there is $2,000 per year in depreciation deductions for the next four years, then the adjusted cost basis for your asset will be $50,000 – ($2,000 * 4) = $42,000.

However, if the sale price of the asset is not more than its adjusted cost basis, you must report the gain from the sale of the property as a capital gain, not ordinary income.

 

Examples of Depreciation Recapture

 

Example 1

  • Purchase price of property: $1,000,000
  • Depreciation deductions claimed in five years: $5,000 per year
  • Sale price in the 6th year: $990,000
  • Depreciation recapture tax rate: 20%
  • Capital gain tax rate: 15%

The adjusted cost basis will be $1,000,000 – ($5,000 * 5) = $975,000.

 

The gain from the sale will be the adjusted cost basis subtracted from the sale price: $990,000 – $975,000 = $15,000. As a result, when filing taxes, the property owner will need to file $15,000 in ordinary income. Since the depreciation recapture tax rate is 20%, the amount to be taxed will be $3,000 ($15,000 * 20%).

Note that if $15,000 is greater than the total amount of depreciation deductions claimed by the owner, the depreciation recapture will equal the amount of depreciation deductions and will be taxed as ordinary income. The remaining amount will be taxed as a capital gain.

 

Example 2

Let’s say the homeowner is selling the property for $1,150,000 and the purchase price and depreciation deductions remain unchanged:

  • Purchase price of property: $1,000,000
  • Depreciation deductions claimed in five years: $5,000 per year
  • Sale price in the 6th year: $1,150,000
  • Depreciation recapture tax rate: 20%
  • Capital gain tax rate: 15%

The adjusted cost basis will still be $975,000.

 

The gain from the sale is $1,150,000 – $975,000 = $175,000. In this case, not all of the amount will be taxed as ordinary income since $175,000 is greater than the total amount of depreciation deductions claimed.

Within $175,000, only $25,000 ($5,000 * 5) is filed as ordinary income because $25,000 is the total amount of depreciation deductions. The rest of the amount, which is $175,000 – $25,000 = $150,000, will be part of capital gain. Since the depreciation recapture tax rate is 20% and capital gain tax rate is 15%, then:

$25,000 * 20% = $5,000 (Amount of depreciation recapture that is taxed)

$150,000 * 15% = $22,500 (Amount of capital gain that is taxed)

 

Other Important Points to Consider

  • In 2019, depreciation recapture on gains related to the sale of the property was capped at a maximum of 25%. The rest will be taxed as a capital gain.
  • In the U.S., depreciation recapture is governed by sections 1245 and 1250, according to the Internal Revenue Code (IRC).
  • There is no depreciation recapture if a taxpayer sells an asset for a loss. However, according to IRC Section 1231, the taxpayer may qualify for the treatment of ordinary loss.
  • If the property is held for one year or less, the gain from the sale of the property will be taxed as ordinary income.

 

Additional Resources

CFI is the official provider of the Certified Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.

In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:

  • Depreciation Schedule
  • Cost Approach (Real Estate)
  • Tax Depreciation
  • Capital Gains Yield

Financial Analyst Certification

Become a certified Financial Modeling and Valuation Analyst (FMVA)® by completing CFI’s online financial modeling classes and training program!