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 deduct 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 reduce ordinary income, any gain from the disposal of the asset must be reported as ordinary income, rather than income from a capital gain.
The IRS publishes depreciation schedules for specific and different classes of assets. These schedules indicate 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 in the year of 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. Gains and losses are realized from the adjusted cost basis, not the original cost basis.
The realized gain 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.
Form 4797
Form 4797 is used 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
If you're using the Depreciation Module in a return, when you indicate that an asset has been sold or otherwise disposed of, the entries needed for Form 4797 including depreciation recapture are calculated. Otherwise, if you need to enter the sale of an asset not in the depreciation module, from the Main Menu of the tax return (Form 1040) select:
- Income
- Other Gains/Loss (4797, 8824)
- Form 4797 - Sales of Business Property
- Enter/Edit 4797 Transactions - Select New, then enter the Description of Property, Date Acquired, Date Sold, Gross Sales Price, Cost or Other Basis, and Depreciation Allowed. When finished, select Ok.
- Select Type of Transaction - Choose either Part I or Part II. If you're not sure which part to choose, consult the instructions for Form 4797.
Entering the sale of residential rental property in TaxSlayer Pro
Example: Residential property was purchased in 2022 for $375,000, and per the tax assessor's records the land is valued at $75,000 and the house at $300,000, a ratio of 80% for the building and 20% for the land. The property was rented during the months of January through April at $1,500 per month. The building has accumulated depreciation through 2024 of $304,000, and the property sold on May 1, 2025 for $500,000.
From the Main Menu of the tax return (Form 1040) select:
- Income
- Rents, Royalties, Entities
- Rents and Royalties - If the property has not already been entered, select New. For the Type of Property, select "Single Family Residence". Enter the address, the number of Fair Rental Days and Personal Use Days. If the rental activity qualifies for QBID, select the reason, whether as a section 162 trade or business or under the Rev. Proc. 2019-38 safe harbor election. When finished, select Ok.
Enter the rental income. Then, create the entry for the property in the Depreciation Module by selecting:
- Expenses
- Depreciation
-
Depreciation Module - Two entries will be made here, one for the building and one for the land. First the building:
- Select New. Enter the description (generally the address), date placed in service, cost ($300,000), accumulated depreciation ($30,000), and depreciation method (MACRS 27.5 YR since this is residential real property).
- In the Depreciation Data Entry window, enter the date of Disposition (05/01/2025).
- Exit back to the Depreciation Module to create an entry for the building.
- Select the Add Another Asset button.
- Enter the description ("land" plus the address), date placed in service, cost ($75,000), and depreciation method (LAND). Since land is never depreciated, there is no accumulated depreciation.
- In the Depreciation Data Entry window, enter the Disposition date (05/01/2025).
Additional Information:
IRS: Publication 544 - Sales and Other Dispositions of Assets