Yes, depreciation recapture is mandatory upon the sale of depreciable business or investment property (such as real estate or equipment) if the sale price exceeds the adjusted cost basis. The IRS requires taxpayers to "recapture" (repay) tax benefits from previously claimed depreciation, taxing it as ordinary income (up to 25% for real estate) rather than lower long-term capital gains rates.
You might be able to minimize the tax hit from depreciation recapture. Potential strategies include purchasing replacement property in a Section 1031 exchange, timing the sale of business property to when you're in a lower tax bracket, and investing in a Qualified Opportunity Fund.
Strategies to Avoid or Minimize Depreciation Recapture
The IRS allows you to deduct the cost of the loss of value equally over the life of the property on your taxes, referred to as depreciation. However, if you then end up selling that property for profit, there's recapture of depreciation, so that you don't benefit both when you use the property and when you sell it.
If you don't claim your depreciation deduction, you pay the total penalty upon the sale of the property but still forfeit any tax benefits while you own it. It's best to claim the deduction each year and plan accordingly, which can involve paying the total recapture tax or finding strategies to avoid it.
They want to avoid depreciation recapture
However, the IRS requires owners to pay the depreciation recapture tax regardless of whether they claimed the depreciation expense over their holding period. So, instead of eliminating the tax liability, skipping depreciation may actually increase your overall tax liability.
Under the Income Tax Act, businesses can claim depreciation as a mandatory deduction in their profit and loss account when they use depreciable assets for business or professional purposes. Depreciation can be claimed using two methods: Written Down Value (WDV) Method – the most commonly used method across industries.
Though depreciation itself doesn't require former property owners to pay back their deductions, the IRS does have plans in place that are designed to recapture a portion of the property's previously claimed depreciation upon its sale.
Knowledgeable taxpayers know depreciation recapture isn't always bad. Sometimes the net present value of tax savings exceeds the recapture tax. The recapture doesn't entirely cancel out benefits realized during the depreciation period.
When you sell a fully depreciated asset, the gain from the sale may be subject to depreciation recapture tax. Depreciation recapture is the process of taxing the portion of the gain that corresponds to the depreciation deductions you've previously claimed.
In summary, the three triggers of recapture are disposition, noncompliance and casualty loss.
The "6-year rule" for investment property, primarily an Australian tax concept (ATO), lets you rent out your former main home for up to six years while still potentially claiming the main residence exemption (CGT-free) on it, provided you lived there first, don't claim another property as your main residence for that period, and either move back in or sell within the timeframe. The clock resets if you move back in for a significant time (e.g., 6+ months) and then rent it out again, but you can only have one main residence exemption at a time.
Some investors may be tempted to skip claiming depreciation to avoid the risk of depreciation recapture tax, but this generally won't succeed. The IRS assumes that you have taken a depreciation deduction. You will owe 25 percent of what you could have deducted as a “depreciation recapture” when you sell the property.
If the asset's sale results in a capital gain, it triggers a depreciation recapture tax liability. If the asset is sold at a loss, depreciation recapture will not apply. There is a capital gain if the taxpayer sells the asset for more than the adjusted basis.
To avoid capital gains tax on a rental property, you can use a 1031 Exchange to defer taxes by reinvesting in a similar property, convert the rental to your primary residence for the Section 121 exclusion, offset gains with losses (tax-loss harvesting), donate the property to charity via a Charitable Remainder Trust, or hold it until death (stepping up the basis). Each strategy has specific rules and timelines, with 1031 exchanges requiring you to find a replacement property within 45 days and close within 180 days.
You Get a One-Time Tax Deduction
In your case, it will be a negative adjustment which is a good thing. It means the IRS will let you deduct all the missed depreciation in one lump sum in the year you make the correction. This could reduce your taxable income significantly and lower your overall tax bill for that year.
Depreciation expense is an expense account, therefore, not recording the depreciation would understate the total expenses. In effect, the net income would be overstated, because expenses are deducted to arrive at the amount of net income for the period.