A frequent question we receive is the tax treatment of recaptured depreciation from the sale of real estate rental property. Gain from selling Sec 1250 property (real estate) is subject to recapture – the excess of the actual amount of depreciation previously claimed for the property over the amount of depreciation that would have been allowable under the straight-line method, limited to the gain on the sale, is taxed as ordinary income. However, this means that as long as the property is being depreciated using a straight-line method and held over a year, there is no Sec 1250 recapture but there will be “unrecaptured Sec 1250 gain,” which is taxed at a maximum rate of 25%. The balance of the gain, if any, is taxed at the normal capital gains rate based upon the individual’s regular tax rate, as follows:
- The LTCG tax rate is zero to the extent the taxpayer’s taxable income bracket is below 25%.
- The LTCG tax rate is 15% to the extent the taxpayer’s taxable income bracket is above 25% and below 39.6%
- The LTCG tax rate is 20% to the extent the taxpayer’s taxable income bracket is 39.6%
Rental real estate depreciation rates have been mandatorily straight line since 1987 with residential rentals being depreciated over 27.5 years and commercial property depreciated over 31.5 years or 39 years if placed in service after 5/12/1993. Thus in nearly all cases it is impossible for real estate property sold in 2017 to have been depreciated at other than straight-line, and therefore no amount of depreciation is recaptured as Sec 1250 gain (Code Sec. 168(b)(3)(A)). But the amount of depreciation claimed on Sec 1250 property that is not recaptured as ordinary income under the Sec1250 recapture rules is unrecaptured section 1250 gain, and is subject to a special capital gain tax rate of 25%.
Example: Jack, an individual, sells nonresidential real property on Aug. 15 for $200,000, realizing a gain of $50,000. This is Jack's only transaction involving a capital asset for the year. Jack held the property for more than one year. He depreciated the property using MACRS (straight-line), and claimed $25,000 of depreciation during his ownership. There is no depreciation recapture under Sec 1250 because Jack didn't claim accelerated depreciation. However, $25,000 of Jack's gain, representing depreciation deductions he had claimed, is unrecaptured Sec. 1250 gain. Lines 26a and 26g of Jack’s Form 4797 will be zeroes because straight-line depreciation was used. The Unrecaptured Section 1250 Gain Worksheet in the Schedule D instructions will need to be completed before Jack’s Schedule D Tax Worksheet can be computed. The maximum amount of tax he’ll pay on the $25,000 of unrecaptured Sec 1250 gain is $6,250 (25% x $25,000) but his tax on the unrecaptured 1250 gain could be much less depending on his other income and the tax bracket he falls into.
Special Recapture Situations
Even if straight-line depreciation is used to claim the regular depreciation deduction, depreciation recapture will apply in the following situations:
Bonus Depreciation – If bonus depreciation is claimed on qualified leasehold improvement property placed in service before 2016 or qualified improvement property placed in service after 2015, the Sec 1250 recapture rules apply. The recapture amount is equal to the difference between the bonus deduction claimed and straight-line depreciation that could have been claimed on the bonus deduction.
- Sec 179 - If a Sec 179 deduction is claimed on Sec 1250 property (e.g., qualified leasehold improvement property, qualified restaurant property and qualified retail improvement property), the Sec 179 allowance is subject to recapture under the recapture rules of Sec 1245. In this case, to the extent the gain is allocable to the expensed portion of the property, the Sec 179 amount may be recaptured in full as ordinary income.