When the asset is subsequently sold, the gain on the sale will be higher since it's basis is now lower. How the gain is treated depends on the type of asset.
Depreciation recapture can cause a significant tax impact for people who are selling residential rental properties. Part of the gain will be taxed as a capital gain and may qualify for the maximum 15% rate on long-term gains. The part of the gain that is related to depreciation, however, will be taxed at a maximum 25% rate. The technical term for gain related to depreciation on residential property is called unrecaptured section 1250 gain.
Tax Planning Tips for Depreciation RecaptureWhen a rental property is sold, any passive activity losses that were not deductible in previous years become deductible in full. This can help offset the tax bite of the depreciation recapture tax.
Also, rental properties can be sold as part of a like-kind exchange to defer both capital gains and depreciation recapture taxes.
There's one tax strategy, however, that will not help. Since depreciation is recaptured when the asset is sold, it is reasonable that some people would avoid claiming depreciation as a strategy to avoid the recapture tax. This strategy does not work, because the tax law requires depreciation recapture to be calculated on depreciation that was "allowed or allowable" (Internal Revenue Code section 1250(b)(3)). From a tax planning perspective, taxpayers should claim depreciation on their property to get a current tax deduction, since they will have to pay tax on the gain due to the depreciation.
Additional Resources about Depreciation RecaptureHere's some resources from the IRS Web site regarding depreciation that I have found helpful and informative:
- Unrecaptured section 1250 gain (from IRS Publication 523)
- Residential Rental Property (IRS Publication 527)
- Sales and Other Dispositions of Assets (IRS Publication 544, especially the section in chapter three dealing specifically with depreciation recapture)
- Instructions for Schedule D [pdf] (there's a worksheet found on page D-9 to calculate the depreciation recapture tax).
- FAQ about Depreciation and Recapture (from the IRS FAQs)