Depreciation is one of the biggest tax benefits for businesses, allowing them to deduct the cost of equipment, machinery, real estate, and other assets over time. However, when a business sells a depreciated asset, the IRS may require depreciation recapture, which converts part or all of the gain into ordinary income rather than capital gains.
Understanding how depreciation recapture works can help business owners and investors make smarter tax planning decisions when selling assets.
Depreciation recapture is a tax provision that applies when a business sells a depreciated asset for more than its adjusted basis. Since depreciation reduces taxable income over time, the IRS requires businesses to recapture some of that tax benefit when the asset is sold at a gain.
The IRS classifies recaptured depreciation under two main sections of the tax code:
For the full statutory rules on asset dispositions and recapture calculations, see IRS Publication 544.
Under IRC section 1245, depreciation recapture applies to the sale of tangible personal property such as:
ABC Corp purchased manufacturing equipment for $50,000 and claimed $30,000 in depreciation over five years.
Sale Scenario 1: Selling for $40,000
Sale Scenario 2: Selling for $55,000
The OBBBA (P.L. 119-21) permanently restores 100% bonus depreciation for most qualified property, generally for property acquired after January 19, 2025, and placed in service after that date, subject to transition rules and elections for the first taxable year ending after January 19, 2025. Treasury and IRS guidance should be reviewed for transition rules and implementation details.
This matters for recapture because the entire cost of an asset is expensed in the year it is placed in service. If you purchase equipment for $200,000 and deduct the full amount under section 168(k), your adjusted basis drops to zero immediately. A sale for any amount above zero triggers dollar-for-dollar ordinary income recapture under section 1245.
Before the OBBBA, the phase-down under the Tax Cuts and Jobs Act had reduced bonus depreciation to 40% for property placed in service in 2025. That meant a smaller portion of cost was expensed upfront, and recapture exposure was correspondingly lower.
With full expensing permanently restored, practitioners advising on asset acquisitions should model the recapture consequences at the time of purchase, not just at the time of sale. For related coverage, see Bizora's analysis of 100% depreciation for qualified production property.
Under IRC section 1250, depreciation recapture applies to the sale of real estate and buildings. However, the treatment is different from section 1245 property.
XYZ LLC bought a commercial building for $500,000 and claimed $100,000 in straight-line depreciation.
Sale Scenario 1: Selling for $650,000
Sale Scenario 2: Selling for $390,000 (Loss)
A cost segregation study reclassifies components of a building (electrical systems, specialized HVAC, site improvements) from section 1250 property to section 1245 property. This accelerates depreciation deductions because section 1245 assets typically have shorter recovery periods (5, 7, or 15 years versus 27.5 or 39 years for buildings).
The trade-off is recapture character. To the extent gain is realized on the reclassified section 1245 components, depreciation allowed or allowable on those components may be recaptured as ordinary income rather than treated as unrecaptured section 1250 gain. The actual recapture depends on the depreciation taken, the amount realized allocated to those assets, and the adjusted basis at disposition.
Practitioners should quantify the recapture exposure created by a cost segregation study before recommending one, particularly for clients who may sell the property within a short holding period.
Depreciation recapture is reported on Form 4797, Sales of Business Property. Part III of the form is specifically designed for recapture calculations under sections 1245 and 1250.
You enter the original cost, total depreciation claimed, and sale price. The form calculates the ordinary income portion of the gain, which then flows to Part II and onto your return.
For high-income individuals, the 3.8% net investment income tax under IRC section 1411 may also apply if the gain is included in net investment income under section 1411(a)(1) and section 1411(b). This can increase the effective federal rate to 40.8% for section 1245 ordinary recapture or 28.8% for unrecaptured section 1250 gain, for taxpayers with modified adjusted gross income above $200,000 (single) or $250,000 (married filing jointly). Whether the NIIT applies depends on whether the activity is passive or otherwise within the scope of section 1411.
When a property owner dies, IRC section 1014(a) provides that the heir receives the property with a basis equal to its fair market value at the date of death. This stepped-up basis eliminates all built-in depreciation recapture.
If you hold a fully depreciated building with $500,000 of unrecaptured section 1250 gain, that recapture disappears at death. For practitioners advising on estate and succession planning, this is one of the most significant planning considerations for highly depreciated assets. For more on how this intersects with broader estate strategies, see Bizora's guide to estate planning and taxes.
A section 1031 exchange can defer gain and related recapture for qualifying real property, but recapture may still be recognized to the extent of boot, recognized gain, or replacement-property limitations. Post-TCJA, section 1031 is generally unavailable for equipment and other personal property.
One important limitation applies to installment sales. Under IRC section 453(i), depreciation recapture must be recognized in the year of sale regardless of whether the taxpayer receives the full payment. You cannot defer recapture income by structuring the sale as an installment note.
Only the gain in excess of the recapture amount qualifies for installment treatment.
For background on the broader tax legislation affecting these provisions, see Bizora's summary of the One Big Beautiful Bill Act.
Depreciation is a powerful tax tool, but when it comes time to sell an asset, understanding depreciation recapture is critical to avoiding unexpected tax bills.
Before selling an asset, calculate potential recapture and explore tax-saving opportunities. For complex recapture scenarios involving cost segregation, multi-asset dispositions, or OBBBA-era bonus depreciation, Bizora gives you citation-backed research across the full IRC with the reasoning trail to support your position.
Section 1250 recapture under IRC section 1250 recaptures only depreciation in excess of straight-line as ordinary income. Since post-1986 real property uses straight-line under MACRS, the ordinary income component is typically zero. Instead, straight-line depreciation triggers "unrecaptured section 1250 gain" taxed at a maximum 25% rate under IRC section 1(h)(1)(E).
For section 1245 property (equipment, vehicles, machinery), all recaptured depreciation is taxed as ordinary income at rates up to 37%. For section 1250 property (real estate), it is taxed at a maximum 25% rate as unrecaptured section 1250 gain under IRC section 1(h)(1)(E). See IRS Publication 544 for the full classification rules.
Section 1245 covers personal property (equipment, machinery, vehicles) and recaptures all depreciation as ordinary income. Section 1250 covers real property (buildings) and only recaptures depreciation in excess of straight-line as ordinary income, which is typically zero for post-1986 property. The practical difference: section 1245 recapture hits at rates up to 37%, while section 1250 depreciation is taxed at a maximum 25% as unrecaptured gain.
Subtract the adjusted basis (original cost minus accumulated depreciation) from the sale price allocated to the building (excluding land). The gain equal to total depreciation claimed is unrecaptured section 1250 gain taxed at the 25% maximum rate, and any remaining gain is taxed at long-term capital gains rates. Report the calculation on Form 4797 Part III.
A section 1031 like-kind exchange can defer gain and related recapture for qualifying real property. Holding property until death eliminates recapture entirely through the stepped-up basis under IRC section 1014(a). In business sales, allocating more of the purchase price to real estate (section 1250) rather than equipment (section 1245) shifts gain from ordinary income rates to the lower 25% rate.
No. The 25% under IRC section 1(h)(1)(E) is a maximum rate, not a flat rate. Taxpayers in brackets below 25% pay their marginal rate on unrecaptured section 1250 gain instead. Most taxpayers selling commercial real estate fall above the 25% bracket, so the cap applies in the majority of cases.
Section 1250 ordinary income recapture only applies to depreciation in excess of straight-line. The Tax Reform Act of 1986 required straight-line for most real property under MACRS, so there is no excess to recapture. The straight-line depreciation is instead taxed at the 25% unrecaptured section 1250 gain rate under IRC section 1(h).
Yes. Regular long-term capital gains are taxed at 0%, 15%, or 20%, while unrecaptured section 1250 gain is taxed at a maximum 25% under IRC section 1(h)(1)(E). The 3.8% NIIT under IRC section 1411 may also apply if the gain is included in net investment income, potentially pushing the effective rate on unrecaptured section 1250 gain to 28.8%.
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