Some assets, such as buildings and machinery, tend to lose value over time. For income tax purposes, the value that is lost on an asset is recognized by the IRS as a depreciation expense for each year. Depreciation allows the owner of an asset used in a trade or business, to divide the cost of the asset over a specified number of years, and use this as an expense against income. Taking depreciation also reduces the adjusted cost basis of the asset. Once the depreciated asset is disposed of or sold for a gain, the 'ordinary income tax rate' will be applied on the amount of 'recaptured' depreciation.
Depreciation recapture is a provision within the tax code that allows the IRS to collect taxes on the profitable sale of an asset that the taxpayer had previously used to offset taxable income. Because depreciation of an asset can be used to deduct ordinary income, any gain from the disposal of the asset must be reported as ordinary income, rather that income from a capital gain.
The IRS publishes depreciation schedules for specific and different classes of assets. These schedules tell a taxpayer the percentage of an asset's value that can be deducted each year, as well as the number of years for which the deductions may be taken.
Depreciation Recapture Calculation
The first step in calculating depreciation recapture is to determine the cost basis of the asset. In general, the original cost basis is the price paid to acquire the asset. The 'adjusted cost basis' is the original cost basis minus any allowed or allowable depreciation expense incurred. For example, if a machine used in a business was originally purchased for $20,000 and allowable depreciation was $2,000 per year, the 'adjusted cost basis' after five years would be $20,000 - ($2,000 X 5) = $10,000.
If the machine were sold at a gain, the depreciation would be recaptured on the tax return that covered the year of the sale. For example, if the machine were sold for $13,000, the business would have a taxable gain of $13,000 (sale price) - $10,000 (adjusted basis) = $3,000.
It's easy to think that a loss occurred from the sale of the machine since it was originally purchased for $20,000 and sold for $13,000. But, gains and losses are realized from the 'adjusted cost basis' and not the original cost basis.
The realized gain (often resulting from selling an asset at a price higher than the original purchase price) from the sale of an asset is compared with the depreciation expense. The smaller of the two figures is the 'depreciation recapture'.
From the example above, the realized gain on the sale of the machine is $3,000. The depreciation expense is $10,000. The depreciation recapture is, therefore, $3,000. This recaptured amount is treated as ordinary income on the tax return for that year. There is no depreciation to recapture if a loss was realized on the sale of a depreciated asset.
Depreciation Recapture on Rental Property
Generally, part of the gain from the sale of residential rental property is taxed at capital gain tax rates, and the part of the gain related to depreciation is taxed at ordinary tax rates. The ordinary tax rates can be significantly higher than the capital gain rates. The term for a gain related to the depreciation on residential rental property is "unrecaptured Section 1250 gain".
For example, assume a taxpayer owns a rental property that was purchased for $350,000 and has an annual depreciation of $20,000. After 11 years, the taxpayer decides to sell the property for $430,000.
The adjusted cost basis of the property is $350,000 - ($20,000 X 11) = $130,000.
The realized gain on the sale of the property will be $430,000 - $130,000 = $300,000.
The capital gain portion from the sale of the property is $300,000 - ($20,000 X 11) = $80,000.
The depreciation recapture portion from the sale of the property is $20,000 X 11 = $220,000.
Entering Depreciation Recapture in the Program (Examples)
Use Form 4797 to report the sale or exchange of:
- Real property used in a trade or business
- Depreciable and amortizable tangible property used in a trade or business
In the Desktop version of TaxSlayer Pro, from the Income Menu, select the option for 'Other Gains / Losses (4797, 8824)' --> 'Form 4797 - Sales of Business Property' --> 'Enter / Edit 4797 Transactions'
Select the 'New' Button and enter the Property Description, Date Acquired, Date Sold, Sales Price, Cost Basis, and Depreciation Allowed
From the instructions for Form 4797, determine where to make the first entry for the asset reported on this form. For example: a machine that was purchased for $22,000; sold at a loss for $20,000; with depreciation taken of $5,000; and held for more than one year, would be entered on Part I of Form 4797.
Adjusted Cost Basis -- $22,000 (original cost) - $5,000 (depreciation) = $17,000
Sales price -- $20,000
Gain on sale -- $20,000 - $17000 = $3,000 (depreciation recapture)
The Gain on the sale is then transferred to Schedule D as a long-term capital gain.
Entering the Sale of Residential Rental Property
How to enter in the TaxSlayer Pro Desktop Version:
Example: Residential rental property rented for 4 months, from January through April, at $1,500 per month = $6,000 in rental income...purchased in 2015 for $300,000, and sold in 2018 for $400,000.
From the Income Menu --> Select 'Rents, Royalties, Entities, (Schedule E)' --> From the Schedule E Menu --> Rents and Royalties --> New Button
Select the type of property (i.e. 'Single Family Residence'); enter the address, along with the number of Fair Rental and Personal Use Days; determine if the rental qualifies for a QBI deduction
From the Schedule E - Rents & Royalties Edit Menu, enter the Rental Income Next, select the Expenses Menu --> Depreciation --> Depreciation Module --> New Button --> Enter Description, Date Placed in Service, Cost, Accumulated Depreciation (for our example, $30,000), and Depreciation Method (MACRS 27.5 Yrs for Residential Rental Property) At the Depreciation Data Entry Screen, select Disposition and answer 'YES' - enter the Disposition (sale of the property) date - for our example, enter May 1st
Answer YES to 'Carry the Disposition to Form 4797?'
Enter the Sales Price of the property to carry to Form 4797 (for our example, $400,000)
Generally, the sale of residential real property will be entered in Part III of the Form 4797 (Section 1250 property)
The sale of land associated with the rental property will go to Part I of the Form 4797
Per the example:
- Cost of rental property - $300,000
- Sales Price - $400,000
- Depreciation Allowed (including the current year's depreciation) - $34,091
- Adjusted Basis -- $300,000 - $34,091 = $265,909
- Realized Gain -- $400,000 - $265,909 = $134,091
- Capital Gain portion -- $134,091 - $34,091 = $100,000
- Ordinary Income Portion - $34,091