There’s Always a Catch: Depreciation Recapture

When you dispose of depreciable or amortizable property that is used in a trade or business or is held for the production of rental income for over one year, the resulting gain is eligible for long-term capital gain treatment under Section 1231. But as always, there is a catch. And that catch is called depreciation recapture.

The depreciation recapture rules were created to prevent the offsetting of depreciation deductions with ordinary income through the recharacterization of gain upon disposition to ordinary income. To say it plainly, because depreciation or amortization taken on assets can be used to reduce ordinary income, a portion or all of the gain from the disposal of these assets must be reported as ordinary income, rather than as capital gains, which as we know, are taxed at more favorable rates.

Depreciation recapture applies to both Section 1245 and 1250 property:

• Section 1245 property consists of either tangible or intangible personal property, as well as certain types of other tangible property, not including buildings and their structural components, that has been subject to an allowance for depreciation or amortization. Section 1245 recapture is computed as the lesser of: (1) allowable depreciation or amortization on the disposed assets, or (2) the gain realized upon the disposition.
• Section 1250 property includes all real property that is not and has never been classified as Section 1245 property. If Section 1250 property is ever converted to Section 1245 property, it can never be categorized as such again. For the purposes of Section 1250, “buildings” can be houses, apartments, factories, office buildings, warehouses or garages, and “structural components” can be items such as walls, floors, windows, doors, HVAC systems and lighting fixtures. Section 1250 recapture is calculated as the lesser of: (1) the excess of accelerated depreciation claimed on real property over what would have been allowed under the straight-line method, or (2) the gain realized upon disposition.
• There is also a concept known as unrecaptured Section 1250 gain. The unrecaptured Section 1250 gain rules do not affect the rules for Section 1250 recapture. Unrecaptured Section 1250 gain cannot exceed the net section 1231 gain or include any gain that is otherwise treated as ordinary income.

A couple more tidbits on depreciation recapture:

• Every sale, taxable exchange, and taxable involuntary conversion constitutes a “disposition” that is subject to recapture. Eligible transactions under Sections 1031 (like-kind exchanges) or 1033 (involuntary conversions) would generally not result in recapture.
• When a transaction involves the disposition of Section 1245, Section 1250, and non-depreciable property like land, the sales price must be allocated across the different classes of assets in order to determine the gain or loss with respect to each class. This can present a pretty cool planning opportunity.
• The sale of Section 1245 and 1250 property for a loss produces a Section 1231 loss. The depreciation recapture provisions only apply to gains, not losses.

Sources: IRS.gov, Bloomberg Tax and RIA Checkpoint