Depreciation Recapture: How the IRS Reclaims Tax Benefits on Asset S

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.

What Is Depreciation Recapture?

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.

Key Rules for Recapture:

1. Applies only when an asset is sold for more than its depreciated basis.

2. The amount of depreciation taken is "recaptured" and taxed as ordinary income.

3. Any additional gain beyond recaptured depreciation is taxed as capital gain (or as a special 25% gain in the case of real estate).

   
   

The IRS classifies recaptured depreciation under two main sections of the tax code:

• Section 1245 (Personal Property & Equipment)

• Section 1250 (Real Estate & Buildings)

  
  

Section 1245 Recapture: Equipment, Machinery, and Personal Property

Under IRC §1245, depreciation recapture applies to the sale of tangible personal property such as:

• Equipment

• Machinery

• Vehicles

• Furniture

• Fixtures

  
  

Tax Treatment Under Section 1245

• The entire amount of depreciation claimed is recaptured as ordinary income.

• Any additional gain beyond the recaptured depreciation is taxed as a capital gain.

  
  

Example of Section 1245 Recapture

ABC Corp purchased manufacturing equipment for $50,000 and claimed $30,000 in depreciation over five years.

Sale Scenario 1: Selling for $40,000

• Adjusted Basis: $50,000 - $30,000 depreciation = $20,000

• Gain on Sale: $40,000 sale price - $20,000 basis = $20,000 gain

• Tax Consequences:

  • $20,000 recaptured as ordinary income (since total depreciation was $30,000, but the gain was only $20,000).

Sale Scenario 2: Selling for $55,000

• Adjusted Basis: $20,000

• Gain on Sale: $55,000 - $20,000 = $35,000 gain

• Tax Consequences:

  • $30,000 recaptured as ordinary income (the amount of depreciation taken).

  • $5,000 taxed as capital gain (excess gain beyond recaptured depreciation).

    
    

Section 1250 Recapture: Real Estate & Buildings

Under IRC §1250, depreciation recapture applies to the sale of real estate and buildings. However, the treatment is different from Section 1245 property.

Tax Treatment Under Section 1250

• The IRS does not recapture straight-line depreciation as ordinary income.

• Instead, depreciation beyond straight-line (such as accelerated depreciation) is recaptured as ordinary income.

• Any additional gain beyond recaptured depreciation is taxed at capital gains rates.

• Unrecaptured Section 1250 Gain is taxed at a special 25% rate instead of normal capital gains rates (which are typically 15% or 20%).

  
  

Example of Section 1250 Recapture

XYZ LLC bought a commercial building for $500,000 and claimed $100,000 in straight-line depreciation.

Sale Scenario 1: Selling for $650,000

• Adjusted Basis: $500,000 - $100,000 depreciation = $400,000

• Gain on Sale: $650,000 - $400,000 = $250,000 gain

• Tax Consequences:

  • $100,000 taxed at 25% as unrecaptured Section 1250 gain.

  • $150,000 taxed as long-term capital gain (15% or 20%).

Sale Scenario 2: Selling for $390,000 (Loss)

• Since the sale price is below the adjusted basis, there is no recapture, and a capital loss may be claimed.

  
  

How Depreciation Recapture Affects Business Sales & Planning

1. Higher Tax Rates on Recaptured Depreciation

• Ordinary income tax rates (which apply to recaptured depreciation) can be as high as 37% for individuals and 21% for C corporations.

• Capital gains tax rates, by contrast, range from 0% to 20% for individuals.

2. The "Five-Year Hold" Strategy for Real Estate

• Holding real estate for more than five years allows taxpayers to take advantage of lower capital gains tax rates on non-recaptured gains.

3. Impact on Business Asset Liquidation

• When selling a business with significant depreciated assets, the buyer and seller must consider how the purchase price is allocated between equipment (1245 property) and real estate (1250 property).

• Allocating more to real estate can reduce depreciation recapture, while allocating more to equipment increases the amount taxed at ordinary income rates.

4. Like-Kind Exchanges to Defer Depreciation Recapture

• 1031 exchanges allow businesses to defer capital gains and depreciation recapture by reinvesting the sale proceeds into a similar type of property.

• This is only available for real estate transactions after the Tax Cuts and Jobs Act (TCJA) of 2017.

  
  

Final Thoughts

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.

• Section 1245 property (equipment, machinery, furniture) has full depreciation recapture as ordinary income.

• Section 1250 property (real estate, buildings) faces a special 25% tax on recaptured depreciation but benefits from lower capital gains rates on the remaining gain.

• Tax planning strategies such as 1031 exchanges, proper allocation in business sales, and timing asset sales carefully can minimize tax consequences.

  
  

Before selling an asset, it’s crucial to calculate potential recapture and explore tax-saving opportunities. Consulting with a tax professional can ensure you make the most of your depreciation deductions while avoiding unnecessary tax burdens.