Selling Depreciated Business or Rental Property? How Depreciation Recapture Can Increase Your Tax Bill
Many business owners and real estate investors understand that Section 1231 can provide favorable tax treatment when business or rental property is sold. However, there is an important limitation that often catches taxpayers by surprise: depreciation recapture.
Although Section 1231 may allow part of a gain to receive favorable long term capital gain treatment, depreciation allowed or allowable during the ownership period can cause part of the gain to be taxed as ordinary income or at a higher maximum capital gain rate.
Understanding how depreciation recapture works before a sale can prevent unexpected tax consequences and create opportunities for more effective tax planning.
- Section 1231 property can generate favorable long term capital gain treatment.
- Depreciation recapture is generally based on depreciation allowed or allowable, even if the taxpayer did not claim every available deduction.
- Section 1245 generally recaptures depreciation as ordinary income when depreciable personal property is sold at a gain.
- For most post 1986 real estate depreciated using the straight line method, Section 1250 ordinary income recapture is often zero.
- Gain attributable to depreciation on real estate may still be unrecaptured Section 1250 gain taxed at a maximum federal rate of 25%.
- Land is not depreciable, so gain allocable to land is not subject to depreciation recapture.
What Is Depreciation Recapture?
Depreciation allows taxpayers to recover the cost of qualifying business and investment property through deductions over the useful life of the property.
When depreciable property is later sold at a gain, the Internal Revenue Code may require part or all of the gain to be recharacterized based on depreciation allowed or allowable during the ownership period.
Allowed depreciation generally means depreciation deductions that were actually claimed and permitted. Allowable depreciation generally means depreciation deductions the taxpayer was entitled to claim, whether or not the deductions were reported on the tax return.
This distinction is important because failing to claim depreciation does not necessarily prevent depreciation recapture when the property is sold. The adjusted tax basis of the property may still be reduced by depreciation that should have been claimed.
How Section 1231 and Depreciation Recapture Work Together
Section 1231 generally applies to depreciable property and real property used in a trade or business and held for more than one year.
If qualifying property is sold at a gain, depreciation recapture is determined first. Only gain remaining after the applicable recapture rules have been applied enters the Section 1231 calculation.
This ordering rule means that a taxpayer cannot automatically treat the entire gain from selling Section 1231 property as long term capital gain.
For a broader discussion of Section 1231 treatment, see my article Selling Business or Rental Property? Why Section 1231 Can Produce Better Tax Results Than Capital Gains.
Section 1245 Recapture
Section 1245 generally applies to depreciable personal property used in a business, including:
- Equipment
- Machinery
- Vehicles
- Furniture and fixtures
- Certain building improvements
- Certain property that received bonus depreciation or a Section 179 deduction
When Section 1245 property is sold at a gain, the gain is generally treated as ordinary income to the extent of depreciation allowed or allowable.
More technically, Section 1245 ordinary income is generally limited to the lesser of the gain recognized or the amount by which the recomputed basis of the property exceeds its adjusted basis. Recomputed basis generally restores depreciation allowed or allowable to the adjusted basis.
Section 1245 Example
A business purchases equipment for $100,000.
The business claims $70,000 of depreciation deductions.
The equipment is later sold for $90,000.
- Original cost: $100,000
- Depreciation allowed or allowable: $70,000
- Adjusted basis: $30,000
- Sale price: $90,000
- Total gain: $60,000
The $60,000 gain is less than the $70,000 of depreciation allowed or allowable. Therefore, the entire $60,000 gain is treated as ordinary income under Section 1245.
None of the gain remains for potential Section 1231 capital gain treatment.
What Happens When Section 1245 Property Sells for More Than Its Original Cost?
Section 1245 recapture generally cannot exceed the depreciation allowed or allowable.
Assume the same equipment with an adjusted basis of $30,000 is sold for $120,000. The taxpayer has a total gain of $90,000.
- $70,000 is generally ordinary income under Section 1245.
- The remaining $20,000 generally enters the Section 1231 calculation.
The remaining Section 1231 gain may ultimately receive long term capital gain treatment, subject to the taxpayer's other Section 1231 gains, losses, and prior year lookback amounts.
Section 1250 and Depreciable Real Estate
Section 1250 generally applies to depreciable real property, including residential rental buildings and commercial buildings.
Section 1250 ordinary income recapture generally applies to additional depreciation in excess of depreciation calculated under the straight line method.
For most post 1986 real estate depreciated using the straight line method, Section 1250 ordinary income recapture is often zero. However, this does not mean the gain attributable to depreciation receives the same tax rate as other long term capital gain.
Gain attributable to depreciation allowed or allowable may be classified as unrecaptured Section 1250 gain. Unrecaptured Section 1250 gain is not ordinary income, but it may be taxed at a maximum federal rate of 25%.
Any remaining qualifying gain may be taxed at the taxpayer's applicable long term capital gain rate, subject to the Section 1231 netting and lookback rules.
Rental Property Example
A taxpayer purchases a rental property for $500,000. Based on the purchase price allocation, $100,000 is assigned to land and $400,000 is assigned to the building.
The taxpayer claims $120,000 of straight line depreciation on the building. The property is later sold, and the taxpayer recognizes a total gain of $200,000 after allocating the sales proceeds between the land and building.
Assuming at least $120,000 of the gain is attributable to the depreciable building:
- Section 1250 ordinary income recapture may be zero because the building was depreciated using the straight line method.
- Up to $120,000 may be treated as unrecaptured Section 1250 gain and taxed at a maximum federal rate of 25%.
- The remaining qualifying gain may receive long term capital gain treatment after applying the Section 1231 rules.
The precise calculation depends on the allocation of the original purchase price, depreciation deductions, selling expenses, capital improvements, and sales proceeds between the land and building.
Land Is Not Subject to Depreciation Recapture
Land is not depreciable property. Therefore, gain allocable to land is not subject to depreciation recapture under Section 1245 or Section 1250.
When real estate that includes both land and a building is sold, the taxpayer must allocate the sales price and selling expenses between the land and the depreciable improvements.
A reasonable and supportable allocation is important because the allocation affects the amount of gain potentially classified as unrecaptured Section 1250 gain.
Cost Segregation Can Create Multiple Types of Gain
A cost segregation study may classify portions of a building as shorter lived personal property or land improvements. Those components may qualify for accelerated depreciation, bonus depreciation, or Section 179 deductions.
When the property is sold, different portions of the transaction may receive different tax treatment.
- Personal property components may generate Section 1245 ordinary income recapture.
- The building may generate unrecaptured Section 1250 gain.
- Land may generate Section 1231 gain without depreciation recapture.
- Gain above the applicable recapture amounts may enter the Section 1231 calculation.
Taxpayers who completed a cost segregation study should review the component level depreciation schedules before selling the property.
Why Investors and Business Owners Are Often Surprised
Many taxpayers estimate their gain by comparing the original purchase price with the expected sales price. This approach can substantially understate taxable gain because it does not account for reductions to basis from depreciation allowed or allowable.
The issue is particularly significant when the taxpayer claimed:
- Bonus depreciation
- Section 179 deductions
- Accelerated depreciation
- Cost segregation deductions
- Depreciation on rental real estate held for many years
A property can sell for less than its original purchase price and still generate taxable gain if depreciation reduced the adjusted basis below the sales price.
The Section 1231 Five Year Lookback Rule Creates Another Layer
After depreciation recapture has been determined, the remaining Section 1231 gains and losses are netted under the Section 1231 rules.
If the taxpayer has a net Section 1231 gain for the current year, the five year lookback rule must then be considered.
Current net Section 1231 gain is recharacterized as ordinary income to the extent of nonrecaptured net Section 1231 losses from the prior five years.
This means a sale may be affected by two separate recharacterization provisions:
- Depreciation recapture under Section 1245 or Section 1250
- The Section 1231 five year lookback rule
For a detailed discussion of the lookback rule, see my article The Hidden Tax Trap in Section 1231: How the Five Year Lookback Rule Can Turn Capital Gains Into Ordinary Income.
Installment Sales Do Not Automatically Defer Depreciation Recapture
An installment sale may spread part of the taxable gain over the years in which payments are received. However, depreciation recapture generally must be recognized as income in the year of sale, even if the taxpayer does not receive all of the sales proceeds during that year.
Only gain remaining after depreciation recapture may generally qualify for installment sale deferral.
This rule can create a cash flow problem when the ordinary income recognized in the year of sale exceeds the cash collected from the buyer during that year.
Tax Planning Opportunities Before a Sale
Depreciation recapture cannot always be avoided, but advance planning can help taxpayers estimate the liability and evaluate available options.
- Review depreciation schedules before listing the property or signing a sales agreement.
- Identify depreciation allowed or allowable, including deductions that may not have been claimed correctly.
- Separate land, building, equipment, and improvement components.
- Review prior cost segregation studies and fixed asset records.
- Estimate Section 1245 ordinary income recapture.
- Estimate potential unrecaptured Section 1250 gain.
- Review nonrecaptured net Section 1231 losses from the prior five years.
- Evaluate the timing of other Section 1231 gains and losses.
- Analyze the immediate recognition of recapture income in an installment sale.
- Consider state income tax consequences in addition to federal tax.
The earlier this analysis is completed, the more accurately the taxpayer can estimate after tax proceeds and evaluate the economic terms of the transaction.
Final Thoughts
Section 1231 can provide favorable tax treatment when business or rental property is sold, but depreciation recapture must be calculated before determining how much gain qualifies for Section 1231 treatment.
Section 1245 can convert gain from equipment and other depreciable personal property into ordinary income. For most post 1986 real estate depreciated using the straight line method, Section 1250 ordinary income recapture is often zero, but gain attributable to depreciation may still be taxed as unrecaptured Section 1250 gain at a maximum federal rate of 25%.
The calculation may become more complicated when a transaction includes land, buildings, equipment, cost segregation components, installment payments, or prior Section 1231 losses.
Before selling rental property or business assets, taxpayers should calculate depreciation recapture, unrecaptured Section 1250 gain, and the Section 1231 lookback consequences. A transaction that appears to produce capital gain may include substantial ordinary income and gain subject to higher tax rates.
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