When you employ the house or commercial property for business purposes, IRS allows you deduction in the form of depreciation every year till you finally sell the property. Depreciation recapture is the amount of the gain attributable to the depreciation deductions previously allowed during the period the taxpayer owned the property. This is so because you already received the benefit of a depreciation deduction that offset ordinary income tax rates which may go upto 39%.
Example of depreciation recapture.
- Purchase cost of house : $20,00,000
- Depreciation deductions claimed in 10 years : $500,000
- Sale value in 11 th year : $50,00,000
- Capital gains : $35,00,000
If there would not have concept of depreciation recapture, the tax would be 20% of $35,00,000= $7,00,000
But the depreciation capture will rewrite computation of long term capital gains as under :
20% on $30,00,000= $6,00,000
25% on $5,00,000= $1,25,000
Total capital gains tax actually levied is= $7,25,000
Two Additional Rules for Depreciation Recapture
- Depreciation recapture is limited to the lesser of the gain or, the depreciation is previously taken. So,in the event a property is sold at a loss the depreciation recapture rules do not apply.
- The 25% depreciation recapture tax rate only applies to the portion of the gain attributable to real property and not attached other asset like furniture etc. The capital gains related to depreciation recapture those other assets would be taxed at the property owner’s ordinary income tax rates.