Depreciation Recapture

Depreciation recapture is the set of rules that tax the previously deducted depreciation when a depreciated asset is disposed of. The logic is straightforward: depreciation reduced ordinary income during the holding period and reduced the asset's basis at the same time, so on sale the code separates out the part of the gain that exists only because of those deductions and taxes it less favorably than the rest.

No provision is actually headed "depreciation recapture". The name covers section 1245, which recaptures depreciation on personal property and similar assets as ordinary income; section 1250, which recaptures "additional depreciation" on real property as ordinary income; and section 1(h)(1)(E) together with section 1(h)(6), which create the separate unrecaptured section 1250 gain category for real-property depreciation that section 1250 itself does not reach.

The building. Section 168(b)(3) forces the straight line method on residential rental and nonresidential real property, and section 1250(b)(1) recaptures only "additional depreciation", meaning depreciation in excess of straight line. For any building placed in service under the current system, that excess is zero, so section 1250 ordinary-income recapture has nothing to bite on. What remains is unrecaptured section 1250 gain, defined at section 1(h)(6)(A) as the long-term capital gain that would have been ordinary income if section 1250 had reached all depreciation. That category exists precisely because Congress wanted straight-line real-property depreciation taxed above the ordinary long-term capital gains rates without turning it into ordinary income.

Twenty-five percent is a ceiling, not a rate. Section 1(h)(1) opens by saying the tax "shall not exceed" the sum of its components, and subparagraph (E) applies "25 percent" to unrecaptured section 1250 gain. Because the whole subsection is a cap on the tax rather than a schedule of rates, a seller whose ordinary rate is below 25% pays their own lower rate on that slice. The common shorthand "recapture is taxed at 25%" overstates the bill for a lower-income seller. In the other direction, the net investment income tax can add 3.8% on top for a seller above its modified adjusted gross income threshold, so the practical federal ceiling on that slice is 28.8%.

The contents are a different rule entirely, and this is the half people miss. Section 1245(a)(1) treats gain up to the depreciation taken on section 1245 property as ordinary income, with no 25% ceiling, and section 1245(a)(3)(A) reaches "personal property". A landlord who depreciated a refrigerator, a stove, carpeting, or any of the 5, 7 and 15-year components a cost segregation study carves out of a building has section 1245 property in the sale. The correction "straight line means no ordinary-income recapture" is right about the building and wrong about the rental as a whole. Section 1245 gain is also recognized "notwithstanding any other provision of this subtitle", and section 453(i) says the same thing directly for an installment sale: recapture income is recognized in the year of disposition, and only the gain above it is spread over the installments.

Allowed or allowable. Section 1250(b)(3) defines the depreciation adjustments as those "allowed or allowable", and section 1245(a)(2) uses the same construction. The recapture is therefore measured by what you were entitled to deduct, not by what you actually claimed, so an owner who never took depreciation still faces the recapture on it. Both sections contain a narrow proviso letting a taxpayer who can establish by adequate records that the amount allowed was less than the amount allowable use the smaller figure, but that is an escape hatch carrying a burden of proof, not the default.

What defers it and what does not. A like-kind exchange under section 1031 defers the whole gain including the recapture, and carries the depreciation history into the replacement property rather than clearing it. The principal residence exclusion does not help either: section 121(d)(6) switches the exclusion off for gain up to the depreciation adjustments attributable to periods after May 6, 1997, which is what catches someone who rented out a former home before selling it.

Work out the adjusted basis, which is the original cost plus improvements minus all depreciation allowed or allowable. Subtract that from the net sale price to get the total gain. Then split it: gain attributable to section 1245 property is ordinary income; gain up to the real-property depreciation is unrecaptured section 1250 gain, taxed at a maximum of 25%; and anything left over is ordinary long-term capital gain taxed under the usual schedule.

A hypothetical, ignoring selling costs so the arithmetic stays visible. Ines bought a rental for $300,000 and allocated $60,000 to land, leaving $240,000 of depreciable building. Residential rental property is straight line over 27.5 years, so a full year is about $8,727, and after ten years she has been allowed roughly $87,273. Her adjusted basis is 300,000 minus 87,273, or $212,727.

She sells for $400,000. Her total gain is 400,000 minus 212,727, which is $187,273. Of that, $87,273 is unrecaptured section 1250 gain and is taxed at a maximum of 25%, and the remaining $100,000 is long-term capital gain under the ordinary 0%, 15% or 20% schedule. If her income puts her over the net investment income tax threshold, 3.8% is layered on both pieces.

Now add the contents. Suppose Ines also depreciated $6,000 of appliances to a basis of zero and they went with the property. Whatever part of the sale price is allocated to those appliances is section 1245 gain up to $6,000, taxed as ordinary income at her regular rate with no ceiling. That slice is small in dollars and disproportionately annoying, because it is the piece nobody expects.

Pros

• Recapture only exists because the deductions did, and those deductions came earlier, so the taxpayer still had the use of the money in the meantime.
• The 25% figure is a ceiling, so a seller in a low-income year pays less than 25% on that slice.
• A 1031 exchange defers it entirely for an investor who is reinvesting.
• It does not apply to appreciation. Only the depreciation comes back at the higher rate.

Cons

• It applies to depreciation you were allowed to take even if you never took it, which is a pure loss.
• Section 1245 property is recaptured as ordinary income with no ceiling, and a cost segregation study increases that exposure.
• The net investment income tax can add 3.8% on top for higher earners.
• The principal residence exclusion does not shelter it, so renting out a former home leaves a taxable slice behind.
• A 1031 exchange defers rather than erases it, so the liability travels with the replacement property indefinitely.
• Section 1245 gain cannot be spread over an installment sale, so cash may be due before the sale proceeds arrive.