We often talk about special capital gains treatment for real or personal property we sell. Reality is that real and personal property are not capital assets and don’t fall under these rules. Real property is given favorable gains treatment under section 1231 instead.
Almost from the beginning congress decided that because depreciation can be used to offset ordinary income that special rules should be in place to treat any future gain as ordinary as well. Since the 1960s there have been depreciation recapture rules.
What is depreciation recapture?
Depreciation recapture doesn’t add to a taxable gain it’s a method of determining the tax treatment of any gain. Basically depreciation recapture is a method determining how much of any gain should be treated as ordinary income as opposed to getting a special capital gains treatment.
How it works
Residential Real property (sec 1250 property) generally placed in service after 1986 is not subject to depreciation recapture since MACRS straight line depreciation is required. Property placed in service before that might have a small amount of depreciation over straight line depending on the depreciation method chosen at the time.
Under section 1231 real property is allowed a special gains rate of 25%.
Personal property (Section 1245 property) is subject to depreciation recapture any time there is a capital gain based on the amount of depreciation previously taken.
An important note to consider though is that depreciation is recaptured regardless of whether a tax deduction was taken. Some investors unknowingly create future problems when they fail to take the depreciation allowed when a property is rented.
Depreciation recapture is complicated when cost segregation is performed. The real property portion will likely not be subject to recapture but the personal property will have at least some recapture if there was a gain on sale.