Selling a fully depreciated rental property triggers depreciation recapture, a taxable event where the IRS taxes previously claimed depreciation deductions as ordinary income (up to 25%) rather than lower capital gains rates. You must pay this tax on all allowed or allowable depreciation, even if you did not actually claim it.
One of the most popular ways to defer depreciation recapture is to complete a 1031 exchange, also known as a “like-kind exchange”.
Depreciation expense taken by a real estate investor is recaptured when the property is sold. Depreciation recapture is taxed at an investor's ordinary income tax rate, up to a maximum of 25%. Remaining profits from the sale of a rental property are taxed at the capital gains tax rate of 0%, 15%, or 20%.
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.
The recaptured amount is taxed with ordinary income rates rather than capital gain rates. Any gain above the recaptured amount may be eligible for a more favorable capital gains rate. Depreciation recapture rules also apply to assets that have been fully depreciated as well as those only partially depreciated.
Assets that are fully depreciated (i.e., the net book value of the historical cost less accumulated depreciation is zero) and that are no longer in use must be written off.
When a rental property is sold for more than its adjusted basis (original cost minus depreciation), the IRS may 'recapture' the depreciation deductions previously claimed. This means the taxpayer must pay taxes on the amount of depreciation claimed during ownership, up to a maximum tax rate of 25%.
Disposal of a Fully Depreciated Asset
The accumulated depreciation account is debited, and the relevant asset account is credited. On the disposal of an asset with zero net book value and zero salvage value, no gain or loss is recognized because both the cash proceeds and carrying amounts are zero.
Depreciation reduces a property's cost base and therefore impacts the size of a capital gain (or loss) upon the sale of an investment property. However, depreciation should still be claimed. In this case study we show why.
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.
The "36-month rule" for capital gains tax (CGT) primarily refers to the UK's Principal Private Residence (PPR) Relief, where the final 36 months (or 9 months for most) of a property's ownership period are tax-exempt, even if not lived in, provided it was a main home at some point. In the US, the relevant rule for home sales is the "2-out-of-5-year rule" for the Section 121 exclusion, allowing up to $250k/$500k profit tax-free if owned and used as a main home for 2 of the 5 years before sale, with exceptions for unforeseen circumstances.
Calculation of Capital Gain Where Only a Part of the Block of Assets is Transferred
Sometimes, a fully depreciated asset can still provide value to a company. In such a case, the operating profits of a company will increase because no depreciation expenses will be recognized. Whenever the asset is no longer used by a company or is sold, the asset is removed from the company's balance sheet.
An asset that is fully depreciated and continues to be used in the business will be reported on the balance sheet at its cost along with its accumulated depreciation. There will be no depreciation expense recorded after the asset is fully depreciated.
Depreciation accounts for the fact that business property tends to wear down over time and lose value. However, if you sell it for a profit, depreciation is recaptured at ordinary income tax rates. After depreciation recapture, regular capital gains tax rates apply.
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.
Your capital gain (profit) is $200,000. Your taxable capital gain with the 50% discount applied is $100,000. Your estimated capital gains tax obligation is $37,175.
The "6-year rule" for Capital Gains Tax (CGT) in Australia allows you to treat a former main residence as tax-exempt for up to six years after you move out, even if you rent it out, enabling you to avoid CGT on any growth during that period. You qualify by moving out, choosing to treat it as your main home for tax, and can reset the rule by moving back in. If you rent it out for longer than six years, only the portion of the gain after the six-year mark becomes taxable.