Understanding tax terms: depreciation recapture

reduce your tax bills, property taxes, and real estate probate costs or apply depreciation recapture rulesOne of the more unpleasant surprises that can hit a taxpayer occurs when you sell personal property, rental property, or assets from your small business. This tax surprise is often associated with depreciation recapture rules.

Depreciation recapture

Depreciation recapture refers to reducing the cost of an asset sold by the prior period’s depreciation expense to determine whether taxes are owed on the sale of an asset and to determine the type of tax that must be paid on the sale of the asset.

When you have business property with a useful life of over one year, you often can deduct part of that property’s cost over the estimated useful life (recovery period) of that property. Small businesses and rental property owners are the most common users of these depreciation rules.

When the asset sells, the IRS wants you to determine if any tax is due as either ordinary income or as a capital gain.

A simplified example: Assume you run a small business outside your home. You purchase a new computer used 100% by your small business. The cost of the computer is $3,500. IRS rules determine you may recover the cost of this type of asset over five years. So, each year, you can deduct $700 as depreciation (1/5 of the cost of the computer, assuming that you are using straight-line depreciation) on your business tax return.

Next, assume the computer was sold at the end of year three for $2,000. This will result in a taxable event that includes depreciation recapture.

Depreciation recapture example

This example is simplified for clarity. Actual depreciation methods used will vary from this example. Because of the depreciation taken in prior years, you must claim the ordinary income on your tax return. This illustrates the recapture of prior period depreciation.

When it occurs

Look for the possibility of depreciation recapture when:

  1. You sell rental property
  2. You sell your home that you have used as a home office
  3. You sell any property used within a small business

Warning: Understand the allowed or allowable trap.

One of the land mines surrounding depreciation recapture rules is the concept of “allowed or allowable.” When calculating whether you owe depreciation recapture-related taxes, the tax code requires that you adjust for depreciation whether or not you actually took the depreciation expense in prior years. So, if you have assets that should be depreciated on your tax return but are not, please call for a review of your situation.

What you should know

First and foremost, many unsuspecting landlords forget that years of depreciation on their property can impact their tax obligation when the property sells. This can occur even if the sales price is less than what they paid for the property.

Secondly, the tax code applies different tax rates on ordinary income versus depreciation recapture versus long-term capital gains. The maximum tax rates on each are:

  • Personal income tax: 37.0%
  • Depreciation recapture: 25.0%
  • Long-term capital gains: 20.0%

Note: This excludes the impact of possible Affordable Care Act surtax.

Unfortunately, the tax laws in this area are fairly complex. Multiple variable can impact the amount due, such as:

  • Different depreciation methods
  • Use of Section 179 and bonus depreciation rules
  • Improvements made to property
  • Like-kind exchange rules
  • Asset class designations

You do not need to understand the complexities surrounding depreciation recapture rules. Rather, you simply need to know they exist and ask for assistance. As always, feel free to contact our RRBB advisors if you have questions.


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