How does the recapture of depreciation work when selling commercial rental real estate?

When selling commercial rental real estate, the recapture of depreciation is governed primarily by the rules in Internal Revenue Code (IRC) sections 1245 and 1250, with section 1250 being the most relevant for most commercial real estate. Here’s a comprehensive explanation of how depreciation recapture works in this context, including the calculation, tax treatment, and reporting requirements:

1. What Is Depreciation Recapture?

Depreciation recapture is the process by which the IRS “recaptures” some or all of the depreciation deductions you have taken on a property by taxing a portion of your gain on sale as ordinary income, rather than as capital gain. This prevents taxpayers from benefiting from both a deduction at ordinary income rates and a lower capital gains rate on the same amount.

2. Section 1250 Property: Definition

Section 1250 property is defined as depreciable real property (other than section 1245 property, which is generally personal property or certain real property with special depreciation) that is or has been subject to an allowance for depreciation.

For commercial rental real estate, this means:- Office buildings, retail centers, warehouses, and other nonresidential real estate.- Residential rental property (apartments, etc.) is also section 1250 property, but the recapture rules are slightly different for residential vs. nonresidential property.

3. How Is Depreciation Recapture Calculated?

a. Additional Depreciation

For property held more than one year, “additional depreciation” is the amount of depreciation taken (or allowed) in excess of what would have been allowed under the straight-line method.

• For property placed in service after 1986 and depreciated under MACRS, commercial real estate is required to use the straight-line method, so there is generally no “additional depreciation” for section 1250 recapture purposes.
• However, if the property was depreciated using an accelerated method (e.g., ACRS for property placed in service before 1987), the “additional depreciation” is the excess over straight-line.

b. Amount of Gain Treated as Ordinary Income

• The amount of gain treated as ordinary income under section 1250 is the lesser of:
• The additional depreciation taken on the property, or
• The gain realized on the sale (amount realized minus adjusted basis).
• For most post-1986 commercial real estate, since only straight-line depreciation is allowed, there is generally no section 1250 recapture as ordinary income. Instead, the gain attributable to depreciation is taxed as “unrecaptured section 1250 gain” at a maximum 25% rate (see below).

c. Unrecaptured Section 1250 Gain

• Even if there is no “additional depreciation,” the portion of the gain attributable to straight-line depreciation is taxed at a maximum rate of 25% (not as ordinary income, but not at the lower capital gains rate either). This is called “unrecaptured section 1250 gain”.
• The unrecaptured section 1250 gain is the lesser of:
• The total depreciation taken on the property, or
• The total gain on the sale.
• Any remaining gain (i.e., gain in excess of total depreciation) is taxed at the long-term capital gains rate (0%, 15%, or 20%, depending on the taxpayer’s income).

4. Special Rule for Corporations (Section 291)

If the seller is a C corporation, section 291(a) requires that 20% of the amount that would have been recaptured as ordinary income under section 1245 (if the property were section 1245 property) over the amount recaptured under section 1250 is also treated as ordinary income.

5. Example Calculation

Suppose you sell a commercial building for $1,000,000. Your adjusted basis is $700,000, and you have taken $200,000 of straight-line depreciation. All depreciation was straight-line (as required for post-1986 property).

• Gain realized: $1,000,000 – $700,000 = $300,000
• Depreciation taken: $200,000 (all straight-line)
• Section 1250 recapture as ordinary income: $0 (no “additional depreciation”)
• Unrecaptured section 1250 gain: $200,000 (taxed at up to 25%)
• Remaining gain: $100,000 (taxed at long-term capital gains rates)

6. Reporting Requirements

• The sale is reported on Form 4797, Sales of Business Property, and the recapture amount (if any) is calculated in Part III.
• The unrecaptured section 1250 gain is reported on Schedule D, and the 25% rate is applied.

7. Special Situations

• Like-Kind Exchanges and Involuntary Conversions: If gain is not recognized due to a like-kind exchange or involuntary conversion, the recapture rules apply only to the recognized gain, and any unrecaptured depreciation is carried over to the replacement property.
• Installment Sales: Depreciation recapture is recognized in the year of sale, even if no payments are received that year. The remainder of the gain is reported as payments are received.

8. Summary Table

In summary: When you sell commercial rental real estate, you must recapture as ordinary income any “additional depreciation” (generally only for pre-1987 property). For most post-1986 property, the gain attributable to straight-line depreciation is taxed as “unrecaptured section 1250 gain” at a maximum 25% rate, and any remaining gain is taxed at the long-term capital gains rate. The sale and recapture are reported on Form 4797 and Schedule D.