How to Calculate Depreciation Recapture

Depreciation recapture is a tax provision that allows the IRS to collect taxes when an individual disposes of an asset that he had previously used to offset taxable income. The asset that most commonly gives rise to depreciation recapture taxes is real estate. If an investor owns rental property, he can use the depreciation of the property to offset taxable income. In doing so, he lowers his basis in the property so that when the property is sold, his gain is computed based on the selling price minus his purchase price and all depreciation that he previously claimed. It's very important to calculate your depreciation recapture liability, because depreciation recapture is taxed as ordinary income as opposed to capital gains.

Difficulty: Moderate

Instructions

1. Review the original price you paid for the asset you are selling. As an example, suppose you're selling a rental property that you bought five years ago for $500,000.

2. Add the depreciation expense that you claimed each year for the property. Suppose you claimed $20,000 in depreciation expense each year for five years, for a total of $100,000 in depreciation expense claimed on the property.

3. Subtract the total depreciation expense claimed from the original purchase price of the property to determine your adjusted cost basis. In this example, your adjusted cost basis is $500,000 - $100,000 = $400,000.

4. Subtract the adjusted cost basis of the property from the property's selling price to determine your total gain. If you sell the rental property for $550,000, your total gain is $550,000 - $400,000 = $150,000.

5. Subtract the total depreciation expense calculated in Step 2 from the total gain to compute your capital gain (as opposed to your depreciation recapture gain). In this example, your capital gain on the property is $150,000 - $100,000 = $50,000. Your depreciation recapture gain is $100,000.

6. Multiply your capital gain by the capital gains tax rate and your depreciation recapture gain by your ordinary income tax rate to determine your total tax liability. If the capital gains rate is 20 percent and your ordinary income tax rate is 30 percent, the total amount of tax you owe on the sale of your property equals (20 percent times $50,000) + (30 percent times $100,000) = $40,000.

Tips & Warnings

• If you have operating losses from previous years, you may be able to carry those losses forward to offset taxable income in current and future years. Consult an accountant or a tax professional if you have questions regarding loss carry forwards.
• Ordinary income and capital gains tax rates change frequently. Be sure to consult a tax professional when completing your tax return to ensure that you are using the correct tax rates to calculate your tax liability.

Resources

• IRS - Ordinary or Capital Gain or Loss for Business Property