The IRS therefore recaptures your depreciation, requiring that you pay the taxes you didn’t pay during your period of ownership because you were claiming a deduction. Depreciation recapture can cause a significant tax impact if you sell a residential rental property. Part of the gain can be taxed as a capital gain, and it might qualify for the maximum 20% rate on long-term gains, but the part that’s related to depreciation can be taxed at the 25% depreciation recapture rate. How your gain is recaptured depends on the type of asset in question. Section 1250 of the tax code applies to real estate property, whereas Section 1245 applies to other types of assets. Each sets forth the circumstances under which recapture can be taxed as ordinary income rather than at the 25% rate.
Residential Rental Properties: Section 1250
Section 1250 applies to all property sold or disposed of after December 31, 1975. It provides that any gain on the sale of a property may be taxed as ordinary income, according to your marginal or top tax bracket, based on whichever of the following is less:
The depreciation you claimed The difference between the sales price or fair market value (in the event that you don’t sell the property) and the adjusted basis of the property
Otherwise, it’s subject to the 25% rate rather than the more advantageous capital gains rate.
Other Property: Section 1245
Section 1245 applies to property not including “a building or its structural components,” according to the tax code. A portion of this property is taxed as ordinary income to the extent that the sales price exceeds the lesser of:
The “recomputed” basis of the property by adding back deductionsThe sales price or the asset’s fair market value
Again, the recapture is otherwise taxed at the 25% rate, not at the more favorable capital gains tax rate.
Examples of Depreciation Recapture
As an example, suppose you purchased a rental property for $150,000. You depreciated it for tax purposes at a rate of $5,400 a year for five years. You were in the 32% tax bracket in each of those years, so you avoided $1,728 each year in taxes that you didn’t have to pay: 32% of $5,400 for five years, for a total of $8,640 in savings. You’d owe $6,750 in tax if the IRS taxed your claimed depreciation amount ($27,000 total) at the 25% depreciation recapture rate, and you might owe capital gains tax as well. You saved $8,640 in taxes, so you’re actually only seeing a profit of $1,890—the difference between $6,750 and $8,640—because the IRS effectively reclaimed that depreciation.
Not Claiming Depreciation Won’t Help
It might seem reasonable that you could not claim a depreciation deduction to avoid paying the recapture tax. This strategy doesn’t work, however, because tax law requires that recapture be calculated on depreciation that was “allowed or allowable,” according to the IRS’ tax code. In other words, you were entitled to claim depreciation even if you didn’t, so the IRS treats the situation as though you had.
How To Plan for Depreciation Recapture
Here’s some good news: Passive activity losses that were not deductible in previous years have become fully deductible when a rental property is sold. This can help offset the tax bite of the depreciation recapture tax. A rental property also can be sold as part of a like-kind exchange to defer both capital gains and depreciation recapture taxes. This involves disposing of an asset and immediately acquiring another similar asset, effectively deferring taxes until a later point when a sale is not followed by an acquisition.
Additional Resources About Depreciation Recapture
Here are some additional resources from the IRS website regarding depreciation that you might find helpful:
