Depreciation recapture
Also called Unrecaptured section 1250 gain, Recapture.
Depreciation recapture is the portion of the gain on sale attributable to depreciation previously deducted, taxed at a rate above the long-term capital gains rate. For real property the recaptured amount is unrecaptured section 1250 gain, subject to a statutory rate cap of 25 percent.
How it works
The mechanism is arithmetic rather than policy. Depreciation reduces adjusted basis year by year. Gain on sale is proceeds less adjusted basis. So every dollar of depreciation increases gain by a dollar, and the tax code separates that portion out and taxes it at a higher rate than the appreciation portion.
Real property depreciated on a straight-line schedule generates unrecaptured section 1250 gain, capped at 25 percent. What a cost segregation study pulls out of that basis does not all behave the same way. The five and seven year personal property, the carpeting, cabinetry, appliances and specialty systems, is section 1245 property and recaptures in full at ordinary income rates. Fifteen year land improvements remain section 1250 property, but they depreciate on an accelerated method, so the depreciation taken in excess of straight line is recaptured at ordinary rates as well and only the remainder falls under the 25 percent cap. Either route ends above the cap, which is the main cost side of an aggressive cost segregation position and the reason the categories have to be tracked separately.
The rest of the gain, the amount above original cost basis, is long-term capital gain at the applicable rate. A complete after-tax sale calculation therefore has at least three layers: section 1245 recapture at ordinary rates, unrecaptured section 1250 gain at up to 25 percent, and capital gain on the remainder, plus any applicable state tax and net investment income tax.
Formula
Unrecaptured section 1250 gain = the lesser of total gain and accumulated straight-line depreciation on real property- Adjusted basis = original cost basis + capital improvements - accumulated depreciation
- Total gain = net sale proceeds - adjusted basis
- Gain above the original cost basis is long-term capital gain, not recapture
Worked example
Illustrative. Purchased for $55,900,000, sold after five years for $62,656,017, with selling costs and any capital improvements left out so the layers stay visible. Accumulated straight-line depreciation of $8,130,909.
| Adjusted basis at sale | $47,769,091 |
|---|---|
| Total gain | $14,886,926 |
| Unrecaptured section 1250 gain | $8,130,909 |
| Tax on that layer at the 25% cap | $2,032,727 |
| Long-term capital gain on the remainder | $6,756,017 |
| Recapture tax alone | $2,032,727 |
Recapture is 55 percent of the total gain here and it is taxed at the highest of the applicable rates. On a five-year hold of a recently purchased asset, recapture usually dominates the tax bill, because there has not been enough time for appreciation to outgrow the depreciation taken.
The common mistake
Applying one blended capital gains rate to the whole gain
Taxing the entire gain at the long-term capital gains rate understates the liability whenever accumulated depreciation is large relative to appreciation, which is the normal situation on a short hold. On this example the difference between a blended 20 percent rate and the correct layered calculation is several hundred thousand dollars of after-tax proceeds, which flows straight into the after-tax IRR. Split the gain into its layers and apply each rate separately. Tax treatment depends on individual circumstances and this is a description of mechanics, not tax advice.
Related terms
- DepreciationDepreciation is the annual deduction that lets an owner recover the cost of a building over a fixed period set by statute. It reduces taxable income without reducing cash flow, which is why after-tax returns on real estate exceed pre-tax returns more often than in most asset classes.
- Section 1031 exchangeA section 1031 exchange lets an owner defer capital gains tax and depreciation recapture on the sale of investment real property by reinvesting the proceeds into like-kind replacement property within statutory deadlines. It is a deferral, not a forgiveness: the deferred gain carries into the basis of the new property.
- Cost segregation and bonus depreciationA cost segregation study reclassifies parts of a building into shorter-lived asset categories, typically five, seven and fifteen year property. Bonus depreciation then allows a percentage of that reclassified basis to be deducted immediately rather than over the shorter schedule.
- Internal rate of returnThe internal rate of return is the discount rate at which the net present value of a deal's cash flows equals zero. It expresses a full investment, including the timing of every contribution and distribution, as a single annualised percentage.
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