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Depreciation recapture is a tax term that refers to the process of paying taxes on previously deducted amounts of depreciation when a depreciable asset is sold or exchanged. When a business or individual purchases an asset, such as a piece of equipment or a building, they can take a deduction for the cost of that asset over a period of time, known as depreciation. However, if the asset is sold or exchanged for a gain, the IRS requires that the previously deducted depreciation be ‘recaptured' and taxed as ordinary income at the time of the sale or exchange.
Section 1245 of the Internal Revenue Code pertains to depreciation recapture of certain types of personal property, such as vehicles, equipment and furniture. Under Section 1245, the gain on the sale or exchange of these types of assets is treated as ordinary income to the extent that it exceeds the asset's adjusted basis, which is the cost of the asset minus any depreciation taken. The purpose of Section 1245 depreciation recapture is to prevent taxpayers from getting a double tax benefit by first deducting depreciation and then paying a lower capital gains tax on the sale of the asset.
Unrecaptured Section 1250 Gain is a term used to describe the portion of gain that is subject to a special capital gains tax rate when a depreciable real property is sold or exchanged. Under Section 1250 of the Internal Revenue Code, gain that exceeds the unrecaptured portion of the depreciation is subject to a maximum 25% capital gains tax rate, rather than the normal 20% rate for long-term capital gains. Unrecaptured Section 1250 gain is calculated as the difference between the property's adjusted basis and the lesser of the property's fair market value or the amount realized on the sale.
Suppose an individual purchases a rental property for $150,000 and claims depreciation of $30,000 over a period of time. The adjusted cost basis for the property is $120,000 ($150,000 – $30,000). Later on, the individual sells the property for $250,000. Under Section 1250 rules [1], the individual has realized a gain of $130,000 ($250,000 – $120,000 basis adjusted for depreciation), not $50,000 ($250,000 – $200,000 purchase price). The $30,000 claimed as depreciation is recaptured and taxed at a maximum of 25% [2].
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Section 1231 property refers to real or depreciable business property held for more than one year, as defined by section 1231 of the U.S. Internal Revenue Code. These assets can include buildings, land, and equipment used in a trade or business. Gains or losses from the sale or exchange of Section 1231 property are treated differently for tax purposes. If the section 1231 gains for any taxable year do not exceed the section 1231 losses for such taxable year, such gains and losses shall not be treated as gains and losses from sales or exchanges of capital assets.
Rental property is typically considered Section 1231 property, which is defined as depreciable business property held for more than one year. Section 1231 property includes “property used in a trade or business and property held for the production of income”. This means that any gains or losses from the sale or exchange of rental property would be treated as Section 1231 gains or losses, rather than as capital gains or losses as it would be treated under Section 1250.
On the other hand, IRC Section 1250 applies when certain conditions are met involving depreciation on an investment property. This term generally refers to an adjustment made to reduce taxable profits due to depreciation on an investment asset such as real estate or business inventory. The amount of this adjustment depends on how long the asset was owned by any one taxpayer and what its value was at the acquisition or disposition date – not at previous dates throughout the owner’s holding period.
Additionally, under Section 1231, any net capital gain is taxed at a maximum rate of 15%, while under Section 1250, any unrecaptured gain is taxed at a maximum rate of 25%. It is important to note that rental properties can be classified as both Section 1231 and 1250 properties, depending on the specific circumstances of the property and its use. Therefore, it is important to consult with a tax professional to determine the correct classification for your rental property.
When calculating depreciation recapture, two different formulas are used depending upon your situation. The first formula accounts for straight-line depreciation while explaining any prior years on the macro level; this formula looks like this:
Cash Value – Adjusted Basis Taxable Gain x 25% Taxes Owed
The second formula is similar but takes into account accelerated depreciation; this formula follows as such: Unadjusted Basis x Applied Depreciation % Accelerated Depreciation + Cost Recovery Expenses – State/Local Taxes – Opportunity Zone Credit (if applicable) Accelerated Recovery Threshold Tax Rate x Applicable Federal RateTaxes Owed
One way to avoid depreciation recapture is to exchange the property for another property of “like-kind” under Section 1031 of the Internal Revenue Code. This allows for the deferral of taxes on the sale of the property, as long as the proceeds are reinvested in similar property. Another way is to hold the property until death, as the basis of the property will be reset to its fair market value at the time of death, and any depreciation taken in the past will not be subject to recapture.
In conclusion, there are a few ways to avoid depreciation recapture when selling a property. One option is to exchange the property for another like-kind property through a 1031 exchange. Another option is to hold the property for longer than one year before selling it, as any gains after the one-year mark would be considered long-term capital gains and taxed at a lower rate. Additionally, you can use cost segregation to accelerate the depreciation of certain components of the property, which can lower the amount of recaptured depreciation.
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