what is depreciation recapture 
depreciation recapture is the gain realized by the sale of depreciable capital property that must be reported as ordinary income for tax purposes depreciation recapture is assessed when the sale price of an asset exceeds the tax basis or adjusted cost basis the difference between these figures is thus recaptured by reporting it as ordinary income depreciation recapture is reported on internal revenue service irs form 4797 understanding depreciation recapturecompanies account for wear and tear on property plant and equipment through depreciation depreciation divides the cost associated with the use of an asset over a number of years the irs publishes specific depreciation schedules for different classes of assets the schedules tell a taxpayer what percentage of an asset s value may be deducted each year and the number of years for which the deductions may be taken for tax purposes annual depreciation expense lowers the ordinary income that a company or individual pays each year and reduces the adjusted cost basis of the asset if the depreciated asset is disposed of or sold for a gain the ordinary income tax rate will be applied to the amount of the depreciation expense previously taken on the asset depreciation recapture is a tax provision that allows the irs to collect taxes on any profitable sale of an asset that the taxpayer had used to previously offset their taxable income since depreciation of an asset can be used to deduct ordinary income any gain from the disposal of the asset must be reported and taxed as ordinary income rather than the more favorable capital gains tax rate depreciable capital assets held by a business for over a year are considered to be section 1231 property as defined in section 1231 of the irs code section 1231 is an umbrella for both section 1245 property and section 1250 property section 1245 refers to capital property that is not a building or structural component section 1250 refers to real estate property such as buildings and land the tax rate for the depreciation recapture will depend on whether an asset is a section 1245 or 1250 asset examples of depreciation recapturethe first step in evaluating depreciation recapture is to determine the cost basis of the asset the original cost basis is the price that was paid to acquire the asset the adjusted cost basis is the original cost basis minus any allowed or allowable depreciation expense incurred for example if business equipment was purchased for 10 000 and had a depreciation expense of 2 000 per year its adjusted cost basis after four years would be 10 000 2 000 x 4 2 000 for income tax purposes the depreciation would be recaptured if the equipment is sold for a gain if the equipment is sold for 3 000 the business would have a taxable gain of 3 000 2 000 1 000 it is easy to think that a loss occurred from the sale since the asset was purchased for 10 000 and sold for only 3 000 however gains and losses are realized from the adjusted cost basis not the original cost basis the reasoning for this method is that the taxpayer has benefited from lower ordinary income over the previous years due to annual depreciation expenses gains and losses are realized from the adjusted cost basis not the original cost basis the realized gain from an asset sale must be compared with the accumulated depreciation the smaller of the two figures is considered to be the depreciation recapture in our example above since the realized gain on the sale of the equipment is 1 000 and accumulated depreciation taken through year four is 8 000 the depreciation recapture is thus 1 000 this recaptured amount will be treated as ordinary income when taxes are filed for the year instead assume the equipment in the example above was sold for 12 000 in that case the entire accumulated depreciation of 8 000 is treated as ordinary income for depreciation recapture purposes the additional 2 000 is treated as a capital gain and it is taxed at the favorable capital gains rate there is no depreciation to recapture if a loss was realized on the sale of a depreciated asset unrecaptured section 1250 gaindepreciation recapture on real estate property is not taxed at the ordinary income rate as long as straight line depreciation was used over the life of the property any accelerated depreciation previously taken is still taxed at the ordinary income tax rate during recapture however this is a rare occurrence because the irs has mandated all post 1986 real estate be depreciated using the straight line method part of the gain beyond the original cost basis is taxed as a capital gain and qualifies for the favorable tax rate on long term gains but the part that is related to depreciation is taxed at the unrecaptured gains section 1250 tax rate specific only to gains on real estate property the unrecaptured section 1250 tax rate is currently capped at 25 for example consider a rental property that was purchased for 275 000 and has an annual depreciation of 10 000 275 000 27 5 years allowed by irs for rental property after 11 years the owner decides to sell the property for 430 000 the adjusted cost basis then is 275 000 10 000 x 11 165 000 the realized gain on the sale will be 430 000 165 000 265 000 the unrecaptured section 1250 gain can be calculated as 10 000 x 11 110 000 and the capital gain on the property is 265 000 10 000 x 11 155 000 let s assume a 15 capital gains tax and that the owner falls in the 32 income tax bracket unrecaptured section 1250 gains are limited to 25 the total amount of tax that the taxpayer will owe on the sale of this rental property is 0 15 x 155 000 0 25 x 110 000 23 250 27 500 50 750 the depreciation recapture amount is thus 27 500 