Hamill: When 'depreciation recapture' is recognized after real estate sell

I do real estate tax consulting, and a common question is when “depreciation recapture” is recognized when real estate is sold.

There are two types of recapture rules, one that applies to personal property (called section 1245 property) and the other that applies to real property (section 1250 property).

When property is sold, we need to determine a gain or loss from that sale. That is done by comparing the “amount realized” to the “adjusted basis.”

The amount realized can be money, the fair value of property or the buyer’s assumption (including a payoff) of the seller’s debt.

Tax basis is cost if you purchased the property. It can be other amounts if you acquired the property by gift, inheritance, in a divorce or by exchange.

Adjusted basis means the initial basis adjusted for depreciation claimed through the date of sale.

That’s enough to explain “recapture.” Assume you buy equipment for $100,000. You claim $60,000 of deprecation. You sell the equipment for $75,000.

Financial accountants think of depreciation as matching the decline in value of an asset to the period in which that decline occurred. If measured properly, the depreciation and the decline in value are the same.

Tax accountants do not use depreciation. From 1981 on tax people use a “cost recovery” method. This means that we record deductions based on a statutory rule.

The statutory amount has nothing to do with the actual decline in the value of the property. We are not trying to match anything, just seeking tax deductions.

This is allowed to encourage investment. Cost recovery deductions will almost always exceed the “true” depreciation in the value.

Returning to our example, the adjusted tax basis of the equipment is $40,000 at sale ($100,000 cost minus $60,000 depreciation). A sale for $75,000 produces a $35,000 gain.

There really is no gain. An asset we bought for $100,000 and sold for $75,000 produces a $25,000 loss. But we claimed more depreciation ($60,000) than the decline in value ($25,000).

That is, we already reported a $60,000 deduction. Since the true amount was $25,000, we must now “recapture” the excess deductions claimed.

This is an economic “settling up.” Since prior deductions offset ordinary income (taxed at our highest rate), the recaptured excess deductions so too must be taxed at our highest rate.

Net capital gains are taxed at favorable rates. But these favorable rates are not available to recaptured depreciation.

Recapture can also affect other transactions. For example, if property is sold on an installment basis, where payments are received over time, recapture is still reported immediately.

Things change when the property is real estate. There is no good reason for this other than the power of the real estate lobby.

After 1986 real estate must be depreciated using the “straight-line method.” This is less favorable than what was available before 1987.

Real property depreciation is recaptured only if the amount claimed exceeds the straight-line computation. If we use the required method, that means we have no depreciation recapture.

This is good, because all real estate sale gains can then qualify for favorable capital gain tax rates. The rate cannot exceed 20% of the gain and is even lower for most people.

In 1997, a battle over a tax bill created a new category of gain, called “unrecaptured section 1250 gain.” This applies to real property – section 1250 property. It is not recaptured – it is unrecaptured.

So, it is all capital gain. But the unrecaptured element can be taxed as high as 25% rather than 20%. Again, the actual rate is lower for most people, but the maximum is 25%.

Unrecaptured gain can be reported over time using the normal installment sale rules. It is simply reported first as payments are received.

There are a few situations where section 1250 real property does have “real” recapture. One is if the property is sold within 12 months of acquisition. Then all depreciation is recaptured.

Another is if the property is financed, and the lender either reduces or discharges the debt. Normally this creates income for the borrower. A special rule allows the borrower to reduce depreciable basis and defer income.

When that property is later sold, the gain created by reducing the basis instead of reporting income is treated as recapture taxed as ordinary income.