Depreciation reflects the recognition that certain assets  tend to lose value over time. The IRS generally allows you to categorize the “used up” value of your assets as an expense to offset ordinary income so that special rules should be in place to treat any future gain as well. Depreciation recapture rules have been there since the 1960s.

What is depreciation recapture?

Depreciation recapture doesn’t add to a taxable gain it’s a method of determining the tax treatment of any gain. Basically depreciation recapture is a method determining how much of any gain should be treated as ordinary income as opposed to getting a special capital gains treatment. In reality, real and personal property used in business are not capital assets and do not fall under the capital gain or loss rule.

How it works

The tax rules for recapture differ, depending on whether the property is real property or personal property. There are special rules for depreciation recapture for the listed properties like cars. In addition, there is a special, more generous rule for home offices.

Recapture rules for personal property If you have a capital gain on any depreciable personal property, you must report all or part of the gain as ordinary income to reflect the amount of depreciation allowable, as well as any first-year allowance that you claimed on the asset.

The amount that must be reported as ordinary income (“recaptured”) is equal to the lesser of:

• the total of depreciation and expensing deductions allowable on the asset, or
• the total gain realized

If the total gain realized is more than the amount that must be recaptured and you held the asset for more than one year, the excess will be taxed at the long-term capital gain rate. However, if the total of the depreciation deductions is greater than the gain realized, the entire amount of the gain is reported as ordinary income.

Recapture rules for real estate. Residential Real property (sec 1250 property) generally placed in service after 1986 is not subject to depreciation recapture since MACRS straight line depreciation is required. Property placed in service before that might have a small amount of depreciation over straight line depending on the depreciation method chosen at the time. Real property is given favorable gains treatment under section 1231.

If you realize a gain when you dispose of real estate, you must report all or part of the gain as “recaptured” income to reflect the amount of depreciation claimed on the asset.

The amount that must be recaptured is equal to the lesser of:

• the total depreciation allowable on the asset (except that for home offices, only depreciation for periods after May 6, 1997 counts), or
• the total gain realized

If the total gain realized is more than the amount that must be recaptured, the excess may be reported as a capital gain (with its lower rate) provided that the asset has been held for more than one year. If the total of the depreciation deductions is greater than the gain realized, the entire amount of the gain is taxed at 25 percent rate.

An important note to consider though is that depreciation is recaptured regardless of whether a tax deduction was taken. Some investors unknowingly create future problems when they fail to take the depreciation allowed when a property is rented.