Depreciation Recapture

Depreciation recapture refers to the process implemented by the IRS for gathering Taxes from the Real Estate the value of which is depreciated over time. This depreciation on the property is evaluated when the sale price of the asset goes beyond the adjusted cost Basis.

This depreciation is only applicable to the real estate that is used by the homeowner. At the time of filing taxes, the profits generated from the sale of the real estate should be considered as the ordinary Income, instead of the Capital Gain.

Understanding IRS Depreciation Recapture

The depreciation of assets means the asset loses its worth over a specific period of time. It is specified in the books of accounts along with the profits generated from the asset. In addition to the equipment and machinery, the real estates also depreciate. The cost of depreciation is spread over time.

The Internal Revenue Service (IRS) is in charge of setting the depreciation schedule for different types of assets. They decide the number of years for which the depreciation cost has to be spread and the total value of the asset that will be reduced every year. Despite being an expense, depreciation recapture is beneficial for tax purposes. The tax is charged on the ordinary income of the user, which is generated from the sale of property, business income, and other sources. As depreciation reduces the ordinary income, it also lowers the Tax Liability.

The Internal Revenue Service charges taxes on the sale of the property and any other asset that the user had used for counterbalancing their Taxable Income. The main purpose of depreciation capture is to implement taxes on the ordinary income rather than the Capital gains.

Depreciation Recapture Example

In order to understand how to avoid depreciation recapture, you first need to learn about the cost basis of the property. The cost basis refers to the original cost you had paid for the acquisition of the asset. Simply put, it is the purchase price of real estate. However, the depreciation recapture is calculated on the adjustable cost basis, which is calculated by deducting the depreciation expenses from the original cost basis.

Suppose you purchase machinery for INR 10,000, which incurred the depreciation of INR 3,000 annually.

The adjusted cost basis of this machinery in the next 2 years will be -

INR 10,000 - (INR 3000 x 2) = INR 4,000

If you sell this machinery for gain, the income realized from the sale will be subject to taxes. Let’s say you sell this machinery for INR 5000. So, your total profit will be -

INR 5000 - INR 3000 = INR 2000.

Now, you might think that the asset is sold for a loss, as its purchase price was INR 10,000 and you earned only INR 2,000 from its sale. However, the profits are calculated from the adjusted cost basis, instead of the original price of the asset. The gains are to be compared with the accumulated depreciation to determine the depreciation recapture. In the above example, the depreciation recapture is INR 2000.