Whether you own business assets or a rental home, you have likely heard about depreciation. Depreciation occurs due to the general wear and tear of an asset over the passage of time. The IRS requires that you to take a "depreciation" expense on assets placed into service each year. This expense will offset income just as any other business expense would.
The important thing you should know about depreciation is that if you sell the property or asset for a gain, you are required to calculate the gain but also allocate the portion of the gain attributable to any depreciation recapture.
Depreciation recapture is the procedure for collecting income tax on a gain realized by a taxpayer when the taxpayer disposes of an asset that had previously provided an offset to ordinary income for the taxpayer through the depreciation expense. Because the depreciation expense was ordinary, the tax code requires that the gains be reported as ordinary to the extent of prior depreciation.
Occasionally, clients will ask if they can avoid this by simply not taking the depreciation expense each year. The answer is no. Depreciation must be taken if you are able to take it. When you sell the property, the calculation is using "depreciation allowed or allowable". You will end up being taxed on depreciation recapture even if you did not take it (due to choice or mistake).
Let's apply this to an example: You have owned the property and have been renting it out for the past few years. It's original cost was $100,000 (ignoring land value). You have depreciated $20,000. It's basis is $100,000 – $20,000 = $80,000. You sold it for $200,000. What is the gain and what portion of that is depreciation recapture?
The gain would be $200,000 (sales price) less the basis of $80,000 = $120,000. Of this $120,000 gain, the first $20,000 is allocated to depreciation recapture and taxed at ordinary income tax rates. The remaining $100,000 would be taxed at capital gain rates.
This matters when you are selling property at a gain and could hit you hard from a tax standpoint if you are not prepared. In scenarios where you think you will be impacted by depreciation recapture, consult with your tax professional to be sure you are prepared.