Depreciation recapture most commonly applies when dealing with the sale of improved real estate (such as rental property), as the value of real estate generally increases over time while the improvements are subject to depreciation.
Depreciation recapture in the USA is governed by sections 1245 and 1250 of the Internal Revenue Code (IRC).
Different factors, including tax deductions for depreciation, can lead to an adjusted or recomputed basis for the asset.
Recomputed basis under IRC 1245(a)(2) basically means, with respect to any property, its adjusted basis recomputed by adding all adjustments reflected on account of deductions allowed or allowable to the taxpayer for depreciation.
The IRS publishes specific depreciation schedules for different classes of assets.
Because the taxpayer received a deduction from ordinary income for the depreciation of the asset, any gain the taxpayer receives, up to the depreciation amount, must be included as ordinary income to offset the earlier deduction.
The taxpayer took $400 worth of depreciation deductions from their ordinary income over the course of four years.
Because they received depreciation deductions, they would be required to include the $100 gain as part of their ordinary income.
When a taxpayer takes a loss on the sale of an asset, there is no depreciation recapture.
Under rules contained in the current Internal Revenue Code, real property is not subject to depreciation recapture.
This higher tax rate serves as a rough surrogate for depreciation recapture.