Recaptured Depreciation

When you sell section 1231 property at a gain, part of the gain that is equal to depreciation claimed on the property is reported as an ordinary gain. It gets no favorable tax treatment and is taxed under the same tax rates applied to wages and interest income, for example.

The rule for reporting recaptured depreciation as ordinary gain is as follows:

  • Report as ordinary gain the SMALLER of:
    • Depreciation allowed (or allowable), or
    • The amount of the gain.

Depreciation allowed is what you actually claimed. Depreciation allowable is what you could have claimed using a proper depreciation method.

Three important points about depreciation:

  1. IRS rules state that even if you don't actually claim depreciation, you are deemed to have claimed it anyway. This is referred to as allowable depreciation.
  2. Depreciation allowed is what you actually claimed.
  3. The amount of depreciation recaptured is the lesser of the amount of depreciation allowed (or allowable) or the amount of the gain.

Don't forget to claim depreciation!

IRS rules state that you are deemed to have claimed depreciation on depreciable property even if you did not actually claim any. This is referred to as allowable depreciation. And, you must reduce the basis of depreciable property by the amount of depreciation you could have claimed.

So, make sure you claim depreciation and get the deduction since you're going to be deemed to have claimed it anyway.

To illustrate the recapture of depreciation:

  • Assume you realized a $5,000 gain on the sale of equipment held over one year and you claimed $2,000 of depreciation on the equipment.

Of the $5,000 gain, the $2,000 of recaptured depreciation must be reported as ordinary income. The remaining $3,000 gain is section 1231 gain.

The $3,000 section 1231 gain is the portion of the $5,000 gain that may or may not receive long-term capital gain treatment, depending on whether you have any nonrecaptured net Section1231 losses for the previous five years.

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