Depreciation Recapture on Sale: What Comes Back

Depreciation reduces your basis. When you sell, a lower basis means a larger gain. Recapture rules determine how much of that gain is taxed as ordinary income or at a special rate rather than at the usual long-term capital gain rates. This matters for every study decision because accelerating depreciation shifts more of the eventual gain into these categories. Rules and rates can change, so verify.

The mechanics in three steps

1. Adjusted basis. Original cost basis minus depreciation allowed or allowable.
2. Gain. Sale price less selling costs less adjusted basis.
3. Character. The gain is divided into categories that have different tax rates.

Section 1245 property: personal property

Property such as items classified as 5 or 7 year property is Section 1245 property. On sale at a gain, the gain up to the total depreciation taken is generally recaptured as ordinary income. This is the category that a study most directly affects, because a study moves cost into personal property classes and bonus depreciation may take that cost quickly. The sale price allocated to those items matters. Values of used personal property may be lower than original cost, which limits gain.

Section 1250 property: real property

Buildings and land improvements are Section 1250 property. For property depreciated using straight line, no ordinary recapture generally arises, but depreciation is subject to a special maximum rate discussed in Unrecaptured Section 1250 Gain in Plain Terms. For property depreciated faster than straight line, such as 15 year land improvements with accelerated methods, the excess over straight line can be treated as ordinary income on sale. Bonus depreciation is generally treated as accelerated. Confirm treatment for your assets.

What the rates generally are

Ordinary income is taxed at your ordinary rates. Long-term capital gain is taxed at lower rates. Unrecaptured Section 1250 gain has its own maximum rate. In addition, a net investment income tax may apply to some gains for some taxpayers. See Net Investment Income Tax and Depreciation. Because rates change, verify current rates.

Depreciation allowed or allowable

Basis is reduced by depreciation you were allowed to take or should have taken, whether or not you took it. Skipping depreciation does not avoid recapture. That is one reason correcting missed depreciation is often discussed. See Catch-Up Depreciation With Form 3115.

Why the study raises the recapture question

A study does not create additional depreciation over the life of the asset. It changes the timing and the character of the depreciation. Because some depreciation shifts to personal property, the portion of the gain treated as ordinary may be larger than if all depreciation had been straight line on a building. Whether that matters depends on the hold period and the alternative.

Ways recapture can be reduced or deferred

• Holding the property, so no sale occurs.
• A like-kind exchange of real property. See Section 1031 Exchanges and Depreciation Recapture.
• Offsetting gains with losses, including suspended passive losses released on sale. See Suspended Losses and Carryforwards.
• Selling components at values lower than depreciated cost, which reduces gain.

Partial dispositions

If you replace components, gain or loss can arise earlier. See Partial Dispositions, Replaced Components, and Studies.

A hypothetical illustration

See Hypothetical: Sale and Recapture After a Study for a numerical, labeled hypothetical.

Judging the trade-off

The right way to consider recapture is to compare the tax you avoided earlier, at the rate when you deducted, with the tax you pay later, at the rate on sale, and consider the time between. If you deduct at a high rate and repay at a lower rate years later, the trade can be favorable. If not, less so.

Illustrative allocation of a sale price in words

Imagine you sell a rental for a total price. The buyer and seller agree that some part of the price relates to furnishings and equipment, some to the land improvements, some to the building, and some to the land. The allocation determines how much gain is attributed to each category. If the price allocated to used personal property is low, the gain on that category is small, even though depreciation was large, because the property has little remaining value. If the price is allocated mostly to the building and land, more gain falls in the real property categories. Buyers and sellers sometimes have different preferences, and the allocation must be reasonable and consistently reported.

How the effect scales with the hold period

Recapture affects the outcome only at the time of sale. A property held for decades, with a stepped-up basis at death under rules that may change, might never trigger recapture for the heirs. A property sold after a few years triggers it soon. This is why the hold period is a central variable.

Practical steps before a sale

Ask your preparer for a projected computation before you agree to a price. Ask how each asset class will be treated. Ask whether suspended losses will be released. Ask whether an exchange or installment sale could change the result. Ask about state taxes. Gather your schedules and the study, since they support the computation.

Do not confuse recapture with penalty

Recapture is not a penalty. It is the tax system's way of ensuring that deductions taken against ordinary income are reflected when the property is sold at a gain. Whether the earlier deductions were worth it depends on the comparison of rates and timing, which is the theme of this site.

Next steps

Read Unrecaptured Section 1250 Gain in Plain Terms and Hold Period and the Decision.