What is recaptured depreciation?
Recaptured depreciation is the gain realized on the sale of depreciable capital assets which must be reported as ordinary income for tax purposes. Recaptured depreciation is assessed when the sale price of an asset exceeds the tax base or the adjusted cost base. The difference between these figures is thus “recovered” by declaring it in ordinary income.
Recaptured depreciation is reported on the Internal Revenue Service (IRS) form 4797.
Key points to remember
- Recaptured depreciation is a tax provision that allows the IRS to collect taxes on any profitable sale of an asset that the taxpayer had used to offset taxable income previously.
- Recaptured depreciation on non-real estate is taxed at the taxpayer’s ordinary tax rate, rather than the more favorable capital gains tax rate.
- The recovery of depreciation on gains specific to real estate, called unrecovered gains according to section 1250, is capped at 25% for 2019.
- To calculate the amount of recaptured depreciation, the adjusted cost base of the asset must be compared to the selling price of the asset.
Understanding the recovery of depreciation
Companies record the wear and tear of tangible fixed assets by depreciation. Amortization divides the cost associated with using an asset over several years. The IRS publishes specific depreciation schedules for different asset categories. The appendices tell a taxpayer what percentage of the value of an asset can be deducted each year and the number of years for which the deductions can be made.
The annual depreciation charge for tax purposes reduces the ordinary income that a business or individual pays each year and reduces the adjusted cost base of assets. If the depreciated asset is sold or sold for a gain, the ordinary tax rate will be applied to the amount of the depreciation charge previously taken on the asset.
Recaptured depreciation is a tax provision that allows the IRS to collect taxes on any profitable sale of an asset that the taxpayer had previously used to offset his taxable income. Since the depreciation of an asset can be used to deduct ordinary income, any gain from the disposal of the asset should be reported and taxed as ordinary income, rather than the capital gains tax rate more favorable.
Depreciable fixed assets held by a company for more than a year are considered to be assets of section 1231, as defined in section 1231 of the IRS code. Chapter 1231 is an umbrella for goods from Chapter 1245 and goods from Chapter 1250. Chapter 1245 refers to capital property that is neither a building nor a structural element. Section 1250 refers to real property, such as buildings and land. The tax rate for recaptured depreciation will depend on whether an asset is a Section 1245 or 1250 asset.
Examples of recovery of depreciation
Section 1245 Recaptured depreciation
The first step in assessing depreciation recovery is to determine the cost basis of the asset. The original cost was the price paid to acquire the asset. The adjusted cost base is the original cost base minus any authorized or permitted depreciation expense incurred. For example, if commercial equipment was purchased for $ 10,000 and the amortization charge was $ 2,000 per year, its adjusted cost base after four years would be $ 10,000 – ($ 2,000 x 4) = $ 2,000.
For income tax purposes, depreciation would be recouped 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 arose from the sale since the asset was bought for $ 10,000 and sold for only $ 3,000. However, gains and losses are realized on the basis of the adjusted cost and not on the basis of the original cost. The reasoning of this method is due to the fact that the taxpayer benefited from a fall in ordinary income in previous years due to the annual depreciation charge.
The gain realized on the sale of an asset must be compared to the accumulated depreciation. The smaller of the two digits is considered the recapture of depreciation. In our example above, since the gain realized on the sale of the equipment is $ 1,000 and the accumulated depreciation taken during the fourth year is $ 8,000, the recapture of depreciation is therefore $ 1,000. This recovered amount will be treated as ordinary income when taxes are filed for the year.
Rather, assume that the equipment in the above example was sold for $ 12,000. In this case, all of the accumulated depreciation of $ 8,000 is treated as ordinary income for the purposes of recapturing depreciation. The additional $ 2,000 is treated as capital gains and is taxed at the favorable capital gains rate. There is no depreciation to recover if a loss has been realized on the sale of a depreciated asset.
Gain from section 1250 not recovered
Recaptured depreciation on real estate is not taxed at the ordinary income rate as long as straight-line depreciation has been used over the life of the property. Any accelerated depreciation previously levied is always taxed at the ordinary tax rate upon recovery. However, this is rare because the IRS required that all real estate after 1986 be depreciated on a straight-line basis. Part of the gain beyond the original cost base 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 tax rate not recovered from article 1250 specific only to gains on real estate property. Section 1250’s uncaptured tax rate is capped at 25% for 2019.
For example, consider a rental property purchased for $ 275,000 and whose annual depreciation is $ 10,000 ($ 275,000 / 27.5 years granted by the IRS for rental properties). After 11 years, the owner decides to sell the property for $ 430,000. The adjusted cost base is then $ 350,000 – ($ 10,000 x 11) = $ 240,000. The gain realized on the sale will be $ 430,000 – $ 240,000 = $ 190,000. The unrecovered gain from section 1250 can be calculated as $ 10,000 x 11 = $ 110,000, and the capital gain on the property is $ 190,000 – ($ 10,000 x 11) = $ 80,000.
Assume a capital gains tax of 15% and the owner falls into the 32% tax bracket for 2019. Unrecovered gains under section 1250 are limited to 25% for 2019. The total amount tax that the taxpayer will owe on the sale of this rental property is (0.15 x $ 80,000) + (0.25 x $ 110,000) = $ 12,000 + $ 27,500 = $ 39,500. The depreciation recovery amount is therefore $ 27,500.