Depreciation Recapture: What It Is and How to Calculate It

When you sell a depreciated business asset, you must repay the value of depreciation deductions through a recapture process. The IRS considers some gains from the sale as ordinary income rather than capital gains, enabling it to apply ordinary income tax rates. 

Understanding how depreciation recapture works is essential for maintaining tax compliance when you sell a depreciated asset. It’s also helpful for planning when to buy and sell depreciable assets since factors like how long you’ve held an asset can influence depreciation recapture and associated tax rates.

We’ll explore depreciation recapture, when it’s required, and how to calculate it for Section 1245 and Section 1250 property. We’ll also look at some strategies for minimizing or avoiding your depreciation recapture tax liability so you can create the most effective asset management plan for your small business needs. 

Key Takeaways

• Depreciation recapture allows the IRS to reclaim depreciation deductions when you sell an asset.
• If you sell a depreciated asset for a profit, you must usually pay depreciation recapture.
• Depreciation recapture calculations depend on whether your asset is Section 1245 or Section 1250 property.
• Delaying asset sales, using a 1031 exchange, or setting up a charitable trust can reduce or eliminate depreciation recapture.

Table of Contents

• What Is Depreciation Recapture? 
• When Is Depreciation Recapture Required?
• How to Calculate Depreciation Recapture?
• How to Avoid Depreciation Recapture
• How FreshBooks Simplifies Depreciation Tracking and Recapture
• FAQs About Depreciation Recapture

What Is Depreciation Recapture? 

Depreciation recapture is the cost you must pay when you sell a depreciated asset for a profit. If you own a depreciable asset and claim the depreciation deduction when you file your taxes, you’ve used that asset to reduce your taxable income. If you sell that asset for a profit, the IRS requires you to repay the depreciation deduction you previously claimed.

Depreciation recapture is the difference between the sale price and the adjusted cost basis of the asset. You must report this difference as ordinary income rather than capital gains, which the IRS taxes at a lower rate.

When Is Depreciation Recapture Required? 

In general, you need to calculate depreciation recapture when you sell a business asset for which you’ve previously claimed a depreciation deduction. In some cases, depreciation recapture applies to the depreciation deductions you were allowed to take, even if you didn’t claim them.

Depreciation recapture applies to the sale of business property under Section 1245 or Section 1250, outlined in more detail in the next section. Broadly, it includes things like intangible business assets like patents and copyrights as well as real property assets like commercial buildings.

When determining whether you must pay depreciation recapture, you must account for the asset’s sale price. The amount you pay in depreciation recapture cannot exceed the gains from the sale. Additionally, no depreciation recapture applies if you sold the property for less than the adjusted cost basis.

If the IRS classifies your depreciable business property as Section 1245 or Section 1250 and you sold it for more than the adjusted cost basis, you’re typically required to pay depreciation recapture. The IRS taxes most depreciation recapture as ordinary income, and the rate depends on your tax bracket. In the next section, we’ll explore how to calculate depreciation recapture to help you accurately estimate how much depreciation recapture to pay on different business assets.

How to Calculate Depreciation Recapture? 

How to calculate depreciation recapture depends on the type of asset you hold. The IRS typically divides depreciable assets into 2 categories: Section 1245 and Section 1250 property. The type of asset you hold will determine the tax rate for calculating depreciation recapture.

Section 1245 property generally covers personal depreciable assets you use for business. This property can include intangible assets like patents and copyrights and physical property like research equipment. 

Section 1250 property typically refers to real estate business property. This property includes buildings like warehouses and other commercial spaces, including their structural components. 

Once you’ve determined the type of asset you hold, calculate its adjusted cost basis. This calculation is the price you originally paid for the asset minus any accumulated depreciation expenses. Subtract the adjusted cost basis from the asset’s sale price to calculate depreciation recapture.

In the examples below, we’ll explore the details of calculating the depreciation recapture tax rate for Section 1245 and Section 1250 property.

Depreciation Recapture for Section 1245 Property 

When calculating depreciation recapture for Section 1245 property, you must include all depreciation deductions you’ve taken and any that were allowed, even if you didn’t claim them on your taxes. The IRS will tax these gains as ordinary income. 

Note that the amount considered ordinary taxable income cannot be more than the gains from the sale. The IRS taxes any gains above the depreciation recapture amount as capital gains at the lower tax rate. 

Let’s examine 2 scenarios for depreciation recapture for Section 1245 property:

Scenario 1: Gains Exceed Depreciation Deductions

Five years ago, you purchased research equipment for $10,000. In the last 5 years, you have claimed $2,000 in depreciation deductions. In the sixth year, you sell the equipment for $12,000.

Begin by calculating the adjusted cost basis, the purchase price minus depreciation deductions ($10,000 – $2,000 = $8,000). Your gain is the difference between the sale price and the adjusted cost basis: $12,000 – $8,000 = $4,000.

In this case, your gains exceed the depreciation deductions by $2,000. So, the IRS taxes the first $2,000 as ordinary income at a tax rate according to your tax bracket and the remaining $2,000 as capital gains.

Scenario 2: Gains Are Less Than Depreciation Deductions

Let’s start with the same scenario: You purchased your equipment for $10,000 and claimed $2,000 of depreciation deductions, leaving you with an adjusted cost basis of $8,000. However, you only sell the equipment for $9,000. In this case, your gains are $1,000—less than the amount of depreciation deductions—so the IRS taxes the entire $1,000 as ordinary income.

Depreciation Recapture for Section 1250 Property 

When calculating depreciation recapture for Section 1250 property, it’s important to record how long you’ve owned the asset. If you’ve owned the property for 1 year or less, include any depreciation deductions in the calculation for ordinary income. Like Section 1245 property, the amount the IRS taxes as ordinary income cannot exceed the amount of the gain.

However, if you’ve held your property for more than 1 year, include only the actual depreciation deductions you’ve claimed that are more than the real depreciation. Calculate your real depreciation using the straight-line method, then subtract that from your total depreciation deductions claimed. That amount is the additional depreciation; the IRS will tax it as ordinary income. However, there’s no recapture if your depreciation deductions don’t exceed your real depreciation.

Since this is the most common situation, we’ll explore 2 examples of depreciation recapture for property held for more than 1 year. 

Scenario 1: Gains Exceed Depreciation Deductions

Five years ago, you purchased a warehouse for $500,000. Using the straight-line method, you calculated depreciation deductions of $50,000, giving you an adjusted cost basis of $450,000 ($500,000 – $50,000). You sell the building for $600,000, giving you a total gain of $150,000.

Since only $50,000 of that gain equals the amount of deductions claimed, the IRS considers only $50,000 capital gains but taxed at the ordinary tax rate. The remaining $100,000 is a realized gain taxed at the lower capital gain tax rate.

Scenario 2: Gains Are Less Than Depreciation Deductions

In the same scenario, you purchase a warehouse for $500,000 and claim $50,000 in deductions for an adjusted cost basis of $450,000. You sell the warehouse for $470,000, giving you $20,000 in gains. Since the total gain is less than the depreciation claimed, the IRS treats it as capital gains but may tax it at the ordinary income tax rate.

How to Avoid Depreciation Recapture 

Depreciation recapture increases your taxable income, which can reduce your total profits when you sell business property. The following strategies can help reduce or avoid depreciation recapture so you can realize a larger portion of gains from business property sales:

Make Business Property Sales According to Your Tax Bracket

If you have some flexibility when you sell your business property and expect to be in a lower tax bracket at some point, consider delaying the sale. People approaching retirement or planning to take a break or scale back their business often use this strategy. Since the IRS taxes most depreciation recapture as ordinary income according to your tax bracket, waiting to sell until you’re in a lower tax bracket can reduce the rate at which it taxes your gains.

Use a 1031 Exchange

A 1031 exchange, or like-kind exchange, enables you to defer the recognition of capital gains and depreciation recapture by using the profits from the sale to purchase a similar piece of business property. Note that only Section 1250 property, like buildings and other real property, are eligible for this type of exchange.

Make Use of Qualified Opportunity Funds

A qualified opportunity fund, or QOF, is an investment fund that invests in economically distressed communities. If you use the gains from the sale of business property to invest in a QOF, you can defer the capital gains tax from the asset’s sale. Additionally, if your investment meets specific requirements, including holding the investment for a minimum of 10 years, you may also be able to avoid depreciation recapture from the property sale.

Consider Using a Charitable Trust

Another way to eliminate depreciation recapture is to place the business property into a charitable remainder trust. The trust can then sell the property without being subject to taxes or depreciation recapture.

How FreshBooks Simplifies Depreciation Tracking and Recapture

A clear system for tracking asset depreciation is essential to accurately calculating depreciation recapture. FreshBooks accounting software makes tracking all your assets’ sales, value, and depreciation easy, so your cost value is always up-to-date and accurate. 

FreshBooks offers a straightforward system for managing your business property, including maintaining detailed records of all your purchases and depreciation history. Tax-ready financial reports, including profit and loss reports, help you analyze your spending and gains and equip you with all the information you need for a seamless tax season. Whether you plan to sell an asset or calculate the tax depreciation recapture on a recent sale, try FreshBooks for free to discover how the right accounting software can streamline your business asset management.

FAQs About Depreciation Recapture 

Learn more about selling a fully depreciated property, depreciation recapture on primary residences, and conditions for depreciation recapture with frequently asked questions about depreciation recapture.

What Happens When You Sell a Fully Depreciated Property?

If you sell a fully depreciated property and realize a gain, you will still pay depreciation recapture. Depreciation recapture cannot exceed the amount of your gain, so in many cases, a fully depreciated property will only realize a small gain.

Is a 15-Year Property Subject to Depreciation Recapture?

If you’ve held a property for 15 years, it can still be subject to depreciation recapture. However, the amount will depend on whether it’s Section 1245 or Section 1250 property. For Section 1250 property, assets held for longer than 1 year may be considered capital gains, but the IRS can still tax them at the ordinary tax rate.

Do I Have to Pay Depreciation Recapture on a Primary Residence?

A primary residence isn’t typically considered business property, so it isn’t subject to depreciation recapture. However, if you use this residence for business purposes (such as rental) and claim depreciation as a business asset, you may have to pay depreciation recapture when you sell the rental property.

Do I Have to Pay Depreciation Recapture on a Loss?

If you sell a property for less than you paid, you may still have to pay depreciation recapture. However, if the sale price is less than the adjusted cost basis (purchase price minus depreciation), you are not required to pay depreciation recapture.

Is Depreciation Recapture Mandatory?

Whether depreciation recapture is mandatory depends on the conditions and price of an asset sale. Conditions may include how long you held the asset and the type of asset. Additionally, if your sale price was less than your adjusted cost basis, there is no depreciation recapture.

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