How to Calculate Depreciation Recapture When Selling a Business

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When you sell a business taxed as a passthrough entity or sole proprietorship, the tax consequences can be complex, especially when it comes to depreciation recapture. Depreciation recapture is an Internal Revenue Code statutory tax provision that requires you to “recapture” some or all of the depreciation deductions you previously claimed on business assets held greater than one year and tentatively pay tax on that amount at higher ordinary income rates rather than the lower capital gains rates. Understanding how depreciation recapture works, calculating it, and its impact on your tax liability is essential for individual business owners planning a sale. This article will walk you through the key concepts, calculations, and strategies to help you avoid surprises at tax time.

When Does Depreciation Recapture Apply in a Business Sale?

Key triggers for depreciation recapture:

• • Sale of depreciable business assets (machinery, equipment, vehicles, buildings, etc.)
  • Sale of rental property (including commercial and residential rentals)
  • Sale of a business as a going concern, where the sale includes depreciable assets
  • Like-kind exchanges or involuntary conversions, in some instances

  Depreciation recapture does not apply to the sale of inventory, land (which is not depreciable), or assets that were properly never depreciated. It also does not apply to assets sold at a loss.

  Example:

  If you bought a piece of equipment for $50,000, claimed $30,000 in depreciation, and then sold it for $35,000, your adjusted basis is $20,000 ($50,000 – $30,000). Your gain is $15,000 ($35,000 – $20,000). The IRS will require you to recapture the $15,000 as ordinary income up to the amount of depreciation previously claimed.

Calculating Recapture on Different Asset Classes

The calculation of depreciation recapture depends on the type of asset being sold. The Internal Revenue Code distinguishes between Section 1245 property (generally personal property and specific depreciable real property) and Section 1250 property (generally depreciable real property, such as buildings).

Section 1245 property includes:

• Tangible personal property (machinery, equipment, vehicles, computers, etc.)
• Specific real property that is not a building or structural component (e.g., storage tanks, silos, grain bins)
• Single-purpose agricultural or horticultural structures

Recapture Rule:

When you sell Section 1245 property, all depreciation (including Section 179 and Section 168(k) bonus depreciation) taken on the asset is recaptured as ordinary income up to the amount of gain realized. Any gain above the total depreciation is taxed as a Section 1231 gain (potentially at capital gains rates).

Calculation Steps:

1. Determine the asset’s original cost and total depreciation claimed (or allowed or allowable amount if greater).
2. Calculate the adjusted basis: Original cost minus accumulated depreciation.
3. Calculate the amount realized from the sale (sale price minus selling expenses).
4. Subtract the adjusted basis from the amount realized to determine the gain.
5. The lesser of the gain or total depreciation is recaptured as ordinary income.

Example:

• Original cost: $40,000
• Depreciation claimed: $25,000
• Adjusted basis: $15,000
• Sale price: $30,000
• Gain: $30,000 – $15,000 = $15,000
• Depreciation recapture: $15,000 (all of the gain since it is less than total depreciation) 

Section 1250 property is generally depreciable tangible property that is not Section 1245 property. Typically this involves buildings and their structural components, building systems and land improvements.

Recapture Rule:

For Section 1250 property, only the “additional depreciation” (depreciation claimed in excess of straight-line depreciation) is recaptured as ordinary income. However, for most property placed in service after 1986, straight-line depreciation is required, so there is often no Section 1250 recapture as ordinary income. Instead, the gain attributable to depreciation is taxed at a special “unrecaptured Section 1250 gain” rate of up to 25%—higher than the long-term capital gains rate but lower than ordinary income rates.

Calculation Steps:

1. Determine the total depreciation claimed (or allowed or allowable amount if greater).
2. Calculate the straight-line depreciation that would have been allowed or allowable.
3. The excess of actual depreciation over a straight line is “additional depreciation” and is recaptured as ordinary income.
4. Any remaining gain attributable to depreciation is taxed at the unrecaptured Section 1250 gain rate (up to 25%).
5. Any gain above the original cost is taxed as a Section 1231 gain (potentially at capital gains rates).

Example:

• Original cost: $200,000
• Depreciation claimed: $60,000 (all straight-line)
• Adjusted basis: $140,000
• Sale price: $250,000
• Gain: $250,000 – $140,000 = $110,000
• All $60,000 is unrecaptured Section 1250 gain (taxed at up to 25%), and the remaining $50,000 is Section 1231 gain.

How Recapture Affects Your Tax Liability

Depreciation recapture can significantly increase your tax bill when you sell a business or business assets. Here’s how:

• Ordinary Income Taxation: Recaptured depreciation is taxed as ordinary income. Therefore the lower capital gains rates do not apply. The ordinary income depreciation recapture tax rate is your marginal income tax rate, which can be as high as 37% for individuals in 2025.
• Unrecaptured Section 1250 Gain: For real property, the unrecaptured Section 1250 gain is taxed at a maximum rate of 25%, which is higher than the typical long-term capital gains rate of 15% or 20%.
• Capital Gains Tax: Any gain above the original cost (i.e., appreciation) is potentially taxed at the long-term capital gains rate.

Example of Tax Impact:

Suppose you sell a piece of equipment for a $20,000 gain, all of which is recaptured depreciation. If your ordinary income tax rate is 32%, you’ll tentatively pay $6,400 in federal tax on the recapture. If the gain were taxed as a long-term capital gain at 15%, your federal tax would be only $3,000. This illustrates why understanding how depreciation recapture works is so important for tax planning.

Working With a Tax Advisor to Avoid Surprises

Depreciation recapture is a complex area of tax law, and mistakes can be costly. Here’s how a tax advisor can help you avoid surprises:

• Asset Allocation: In a business sale, the purchase price must be allocated among different asset classes (inventory, equipment, real estate, goodwill, etc.). The allocation affects how much gain is subject to recapture versus capital gains treatment. A tax advisor can help you structure the allocation to minimize recapture.
• Installment Sales: If you sell your business on an installment basis, all depreciation recapture must be reported in the year of sale, even if you receive payments over several years. Your advisor can help you plan for the tax impact.
• Like-Kind Exchanges: In some cases, you can defer gain (and recapture) by exchanging real property for other real property.
• Partial Sales: If you sell only part of your business or specific assets, recapture rules still apply to the assets sold. Your advisor can help you calculate the correct amounts and avoid under or overreporting.
• State Taxes: Some states may have their own rules for amounts of depreciation deductions and/or depreciation that should be considered separately.

FAQ

What is depreciation recapture?

Depreciation recapture is a tax rule that requires you to report as ordinary income some or all of the depreciation deductions you previously claimed on business or investment property when you sell or dispose of the property at a gain. The recaptured amount is taxed at higher ordinary income rates rather than the lower capital gains rates.

What’s the difference between Section 1245 and 1250 property?

Section 1245 Property generally includes tangible personal property (like equipment, vehicles, and machinery) and specific real property that is not a building. Section 1250 property is depreciable tangible property (such as buildings and their structural components, building systems and land improvements) that is not Section 1245 property. The recapture rules are stricter for Section 1245 property, requiring all depreciation to be recaptured as ordinary income, while Section 1250 property often results in a lower recapture amount.

How does recapture apply to partial business sales?

When you sell only part of your business or specific assets, depreciation recapture applies to the assets sold. You must allocate the sale price among the assets and calculate recapture for each asset based on its original cost, accumulated depreciation, and sale price. The recapture amount is reported as ordinary income, and any remaining gain may qualify for capital gains treatment.

Is depreciation recapture taxed as ordinary income?

Yes, depreciation recapture is generally taxed as ordinary income up to the amount of depreciation previously claimed, or allowed or allowable if greater. For Section 1245 property, all recaptured depreciation is taxed at your ordinary income tax rate. For Section 1250 property, only “additional depreciation” is taxed as ordinary income, and the rest may be taxed at a special unrecaptured Section 1250 gain rate of up to 25%.

Conclusion

Depreciation recapture can have a significant impact on the tax outcome of a passthrough entity or sole proprietorship business sale. By understanding the rules, calculating recapture correctly, and working with a knowledgeable tax advisor, you can avoid costly surprises and structure your sale for the best possible tax result. Always plan ahead and seek professional guidance to ensure compliance and tax efficiency..

How Bennett Thrasher Can Help

Navigating depreciation recapture when selling a business can be complex. Our team is here to guide you through the intricacies of tax rules and help you minimize your tax liabilities. For more information, contact Tim Watt or call 770.396.2200.

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