Depreciation recapture occurs when you sell a business asset for more than its depreciated book value. The IRS recaptures the tax benefit you received from past depreciation deductions by taxing that portion of the gain as ordinary income rather than capital gain. Under Section 1245, personal property (equipment, machinery, vehicles) is recaptured at ordinary income rates up to 37%. Under Section 1250, real property recapture is capped at 25%, often called the 'unrecaptured Section 1250 gain' rate.
When your business claimed depreciation deductions on equipment or other assets over the years, it reduced your taxable income each year. When you sell those assets, the IRS requires you to 'recapture' that benefit, meaning the portion of the sale price that represents past depreciation deductions is taxed at ordinary income rates, not capital gains rates.
Under IRC Section 1245, all gain on personal property (equipment, computers, vehicles, machinery) up to the amount of accumulated depreciation is recaptured at ordinary income rates. If you bought a piece of equipment for $100,000, depreciated it to $20,000 book value, and sell it for $80,000, you have $60,000 of Section 1245 recapture, taxed at up to 37% federal.
Under IRC Section 1250, commercial real estate gain is partially recaptured. Specifically, the 'unrecaptured Section 1250 gain', the portion of gain attributable to prior straight-line depreciation, is taxed at a maximum 25% federal rate. Any gain above that amount (true appreciation) is taxed at the regular long-term capital gains rate.
In practice, depreciation recapture is one of the most overlooked tax surprises for business sellers. A company that has owned significant equipment or real estate for many years may have a large recapture exposure that dramatically increases the effective tax rate on the sale. Running a recapture analysis before going to market is an essential step in pre-sale tax planning.
Key facts
- Section 1245 recapture: applies to personal property (equipment, vehicles, machinery), taxed at ordinary income rates up to 37%
- Section 1250 recapture: applies to real property, unrecaptured portion taxed at max 25% federal rate
- Recapture is calculated as: accumulated depreciation taken minus any Section 179 or bonus depreciation taken that exceeded regular depreciation
- Recapture applies even if the asset is sold at a loss relative to its original purchase price, as long as the sale price exceeds the depreciated book value
- Unlike capital gains rates, recapture income can't be offset by capital loss carryforwards
Can I avoid depreciation recapture when selling my business?
Recapture is difficult to avoid entirely in an asset sale. An installment sale (Section 453) can spread the recapture income across multiple years if the buyer agrees to a seller-financed structure, though recapture income is generally recognized in the year of sale unless the installment method applies. A 1031 exchange can defer recapture on real property if proceeds are reinvested in like-kind property within the required timeframe, but this requires specific structuring.
How does bonus depreciation affect recapture exposure?
Bonus depreciation (100% first-year expensing, which has been phasing down after 2022) accelerates depreciation, which means your book value drops faster and your recapture exposure on sale is larger. Assets expensed under Section 179 or bonus depreciation are subject to the same recapture rules, all prior deductions come back as ordinary income on sale.
