Depreciation recapture is the IRS mechanism to prevent a taxpayer from taking ordinary deductions (depreciation) and then converting the economic recovery of those deductions into preferential capital gain on sale. It works by taxing a portion of the gain on sale at ordinary income rates - the portion attributable to depreciation already taken. For properties where bonus depreciation was claimed - expensing the entire cost in year one - the recapture exposure can equal the entire sale price.
The gain on sale of a depreciable asset is bifurcated. The gain that "recoups" previously deducted depreciation is ordinary income (§1245) or taxed at a special rate (§1250). Only gain above the original purchase price is purely capital gain. The effect: a taxpayer who bought equipment for $100K, fully expensed it, and sells it for $60K has $60K of ordinary income - not capital gain - on the sale. There is no capital gain because the sale price is below original cost.
Section 1245 applies to "section 1245 property" - tangible personal property and certain other property subject to depreciation or amortization. This includes equipment, machinery, vehicles, furniture, computers, and §197 intangibles (patents, customer lists, goodwill - to the extent amortized). It also includes personal property components of real estate identified through cost segregation studies.
The §1245 recapture amount is the lesser of: (a) the gain realized on the sale, or (b) the total depreciation and amortization taken on the property since acquisition. §1245 recapture is ordinary income - taxed at regular income rates (up to 37%), not at capital gains rates. There is no cap.
Section 1250 applies to "section 1250 property" - depreciable real property (buildings and structural components). Post-1986 real property must be depreciated straight-line under MACRS, so there is generally no "additional depreciation" above straight-line to recapture as ordinary income under §1250. However, the §1250 unrecaptured gain concept taxes the straight-line depreciation taken on real property at a maximum 25% rate - higher than the 20% long-term capital gains rate but lower than ordinary income rates.
| Type of Gain on Real Property Sale | Tax Rate |
|---|---|
| §1245 recapture on personal property components (cost segregation) | Ordinary income rates up to 37% |
| §1250 unrecaptured gain (straight-line depreciation on building) | Maximum 25% rate under IRC §1(h)(1)(D) |
| §1231 gain above original purchase price | Long-term capital gains rates (0%/15%/20%) |
| NIIT surcharge on investment real estate gain | 3.8% additional (unless real estate professional) |
With 100% bonus depreciation restored permanently by OBBBA, all qualifying personal property placed in service after January 19, 2025 can be fully expensed in year one. This creates very large §1245 recapture exposure on any subsequent sale - the entire sale proceeds (up to original cost) are ordinary income. For business assets that are sold or disposed of within a few years of purchase, the effective tax rate on the sale can approach 37% - effectively eliminating the time-value benefit of the upfront deduction for short holding periods.
When a partner sells their partnership interest, the sale generally produces capital gain. However, IRC §751 requires that the portion of the sale price attributable to the partner's share of "hot assets" - unrealized receivables and substantially appreciated inventory - be treated as ordinary income, not capital gain. Depreciation recapture potential is a "hot asset" under §751.
This means: if a partnership holds equipment with $500K of built-in §1245 recapture, and a partner owns 30%, the partner's $150K share of that recapture potential is §751 income - ordinary income, not capital gain - on the sale of the partnership interest. The partner cannot avoid recapture by selling their partnership interest instead of having the partnership sell the equipment directly.