What Assets are Subject to Depreciation Recapture?

Posted Jan 2, 2023


Depreciation of fixed assets provides an important tax deduction for real estate investors and business owners. 

Depreciation can be applied to a wide range of long-term fixed assets. It’s an important tax provision because it allows businesses or investors to deduct a portion of the cost of buying physical assets over time instead of all at once. Depreciation deductions also lower taxable income, which can help maximize tax savings. 

Let’s take a closer look at how depreciation and depreciation recapture works, and what assets can be depreciated and are subject to depreciation recapture. 

How to Calculate Depreciation on Real Estate 

 There are four different ways businesses and real estate investors can calculate depreciation; however, we’ll focus on the straight-line method since it’s the formula used most often, and it’s also generally considered the easiest way to calculate depreciation. 

Residential properties can be depreciated for 27.5 years, while commercial real estate can be depreciated for 39 years. These numbers represent the “useful life” of both types of properties. Each year, you can deduct 1/27.5th and 1/39th of all costs associated with acquiring and improving residential and commercial real estate, respectively. Land can’t be depreciated because it can’t wear down like a building. 

You can start depreciating real estate after it starts generating rental income. You can continue taking annual depreciation deductions until your entire basis has been met or you divest the asset. 

Here’s the formula for determining your cost basis and depreciation deduction on commercial and residential properties: 

  • Cost of the property less the value of the land equals your basis. 
  • Divide basis by 1/39th to determine annual depreciation deduction for commercial properties. 
  • Divide basis by 1/27.5th to determine annual depreciation deduction for residential properties. 

Real estate investors typically report depreciation on Schedule D of their Form 1040; however, they may use Form 4562 in order to claim depreciation on rental properties for the year in which they were placed into service. 

For other types of depreciable assets, the Internal Revenue Service provides depreciation schedules for the amount and number of years that depreciation can be deducted. 

What Assets Can Be Depreciated – and Recaptured? 

The IRS gave you a tax break when you purchased a depreciable asset. If you sell the asset for any gain, you’ll have to pay taxes on the gain at your marginal tax rate since the depreciation deduction was used to offset your ordinary income. Ultimately, the amount of depreciation recapture you’ll have to pay depends on the sale price of the asset and the accumulated depreciation you claimed during its holding period. 

Depreciation recapture applies to any asset that was depreciated on your tax returns. Income-producing real estate and business equipment are two commonly depreciated items, but depreciation can be claimed on a wide range of tangible capital assets, including: 

  • Vehicles used for business purposes 
  • Machinery and equipment 
  • Computers, peripherals, IT infrastructure, and software 
  • Furniture and fixtures 
  • Land improvements such as exterior lighting 

In order to claim depreciation, an item or real property asset must meet all of the following criteria: 

  • You must own it, and expect to own it for longer than one year. 
  • It has to be in service in a business capacity, or generate rental income. 
  • It has to have a calculable useful life. 

Assets that meet these criteria can be depreciated. If you later sell the asset for a gain, you’ll have to pay depreciation recapture tax on that gain. 

Putting it all Together 

Depreciation commonly involves tangible business assets and income-producing real estate. The depreciation deduction allows business owners and real estate investors to gradually deduct the cost of these capital assets over time, which helps lower their ordinary income. 

Assets that have been depreciated are subject to depreciation recapture upon divestiture if any gain has been realized. If you still have questions regarding depreciation and depreciation recapture, consult with a certified tax professional to discuss your particular situation. 

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.

Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.

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