How Depreciation Recapture Works on Your Taxes

When you sell a depreciated capital asset, you may be able to earn a “realized gain” if the asset’s sale price is higher than its value after deduction expenses. You’ll then be able to recapture the difference between the two figures after you report it as income. Depreciation recapture is popular among taxpayers because it allows them to save money on their taxes. Instead of accounting for your asset’s entire value at the date of your purchase, you can spread out its cost over time, allowing you to earn tax deductions for its duration. If you want hands-on guidance when it comes to lowering your tax liability on your investments, consider enlisting the help of a trusted financial advisor in your area.

What Is Depreciation Recapture?

Depreciation recapture is a process that allows the IRS to collect taxes on the financial gain a taxpayer earns from the sale of an asset. Capital assets might include rental properties, equipment or even furniture. Once an asset’s term has ended, the IRS requires taxpayers to report any gain from the disposal or sale of that asset as ordinary income.

The depreciation recapture conditions for properties and equipment vary. A capital gains tax applies to depreciation recapture that involves real estate and properties. The depreciation recapture for equipment and other assets, however, doesn’t include capital gains tax. But you should understand exactly how depreciation works before we delve deeper into recapture. Below, we take a closer look at how depreciation works.

Depreciation Explained

Businesses or taxpayers often use depreciation to write off the value of a fixed asset they’ve purchased. This allows taxpayers to benefit gradually and save on taxes. The value the asset loses represents its depreciation expense. If the asset’s value slowly decreases over time, rather than instantly, you can still earn revenue from it. This enhances net income and makes your investment more profitable.

But the IRS determines the depreciation schedule, the deduction rate and the deduction term. The depreciation schedule represents the time frame a taxpayer plans to write off an asset’s value. But the taxpayer determines the salvage value. The salvage value indicates the estimated value of an asset once its depreciation schedule has ended.

Some companies estimate an asset’s salvage value to be $0 by the end of its term. But businesses may also estimate a higher salvage value. This could either be for bookkeeping records following the depreciation expense period or because a company wants to sell the asset’s remaining value.

Depreciation Recapture for Rental Properties

One of the biggest differences between depreciation recapture for equipment and rental properties is that the final recapture value for properties takes capital gains tax into account. This means that any gain you earn from selling your property will incur both capital gains taxes and other taxes. The IRS taxes part of your gain as capital gain, and it taxes the depreciation-related portion at a higher rate.

The IRS refers to the gain that specifically relates to depreciation as “unrecaptured section 1250 gain.” This rule states that the depreciation recapture on real estate property is not taxed as ordinary income as long as a straight-line depreciation was used over the life of the property. So part of the gain beyond the original cost basis would be taxed as a capital gain but the part that relates to depreciation is taxed at the 1250 rule rate. The unrecaptured section 1250 rate is capped at 25% for 2023.

How to Calculate Depreciation Recapture

To calculate your depreciation recapture for equipment or other assets, you’ll first need to determine your asset’s cost basis. The cost basis is the original price at which you purchased your asset. You’ll also need to know the adjusted cost basis. This value represents the cost basis minus any deduction expenses throughout the lifespan of the asset. You could then determine the asset’s depreciation recapture value by subtracting the adjusted cost basis from the asset’s sale price.

If you bought equipment for $30,000 and the IRS assigned you a 15% deduction rate with a deduction period of four years, your cost basis is $30,000. Your deduction expenses would be $4,500 per year. To determine the adjusted cost basis, you’d multiply four by your yearly deduction cost and subtract that from the cost basis. Your adjusted cost basis would therefore equal $12,000. If you sold the asset for $13,500, you’d also have to account for other fees or commissions. If those fees cost you $300, you’d subtract that from the sale price. This value would be your net proceeds. You’d then subtract $12,000 from that value to earn a realized gain of $1,500.

However, if there was a loss at the point of the depreciated asset’s sale, you wouldn’t be able to recapture a depreciation. It’s important to remember that gains and losses are based on the adjusted cost basis and not the original purchase value. When you file your taxes, the IRS will treat your recapture as ordinary income. The IRS will also compare the asset’s realized gain with its depreciation expense. The smaller figure serves as the depreciation recapture. This also applies to real estate and rental properties.

For rental properties, you’d use the same approach to find the adjusted cost basis and deduction expenses. The only difference is that the capital gains tax rate and other taxes impact your realized gain.

Bottom Line

Depreciation recapture can be a useful approach to saving on taxes when it comes to capital assets. Whether your assets classify as rental property or equipment, you’ll be able to generate realized gain, and possibly even capital gains tax benefits, as long as your asset’s sale price exceeds its adjusted cost basis. If you’re interested in taking the depreciation recapture approach to saving on taxes, you should also pay attention to the IRS’s depreciation guidelines, as well as current tax rates.

Tips for Calculating Your Taxes

Whether you need help with retirement planning, estate planning, tax planning or investment portfolio organization, a financial advisor can help. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have free introductory calls with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
When it comes to assets, whether property or equipment, it’s important to do your research about the depreciation guidelines the IRS sets. This will give you a better idea of both your deduction term and rate, as well as your potential tax deductions.
If you don’t know whether you’re better off with the standard deduction versus itemized, you might want to read up on it and do some math. You might find that you’d save a significant amount of money one way or another, so it’s best to educate yourself before the tax return deadline.