How Depreciation is Recaptured

[Dave Toelkes]

Investors have long known that depreciation on depreciable real estate is an economic fiction. Since property values usually increase over time, depreciation has often been called a "phantom" expense. Congress even recognized this fact and instituted changes to the US tax code that introduced what is known as "depreciation recapture."

Suppose you buy $75,000 of depreciable real estate and depreciate it by $10,000 during your holding period. The property's book value (cost minus depreciation taken) would then be $65,000.

Now by selling the property for anything more than $65,000, you demonstrate that your $10,000 of depreciation was a phantom expense. The property did not depreciate at all -- it went up in value.

If you sell the property for between $65,000 and $75,000, the amount of the selling price that exceeds $65,000 is the amount of depreciation that DID NOT really occur. Depreciation that did not really occur is said to be "recaptured" at the time of the sale. You must pay tax on it to make up for the deductions you took (or should have taken) previously.

Consider the following examples. In each case, an investment property is purchased for $100,000 and depreciated by $20,000 during the holding period -- reducing the book value to $80,000 at the time of sale.

Case 1: The property is sold for $120,000 or $20,000 more than the original cost. The taxable gain on this sale (sale price minus book value) is $40,000. The first $20,000 of this gain is depreciation recapture, and the rest is a capital gain.

Case 2: The property is sold for $92,000. The sale proceeds exceed the book value of $80,000, but do not exceed the original cost of the property. In this case, the $12,000 of gain on the sale is considered a depreciation recapture and there is no capital gain. The reader should note that although the property was sold for less than its original cost, there is no loss for tax purposes because the property was sold for more than its book value.

Case 3: The property is sold for $76,000 which is $4,000 less than its book value at the time of the sale. There is no depreciation recapture and no capital gain. Instead, there is a capital loss of $4,000.

Currently, the depreciation recapture tax rate is 25%, while the maximum long-term capital gains tax rate is 15%.