When disposing or selling depreciated assets, a taxpayer may have to recognize a portion of the gain as ordinary income under depreciation recapture rules, notes the Internal Revenue Service. The remaining gain is a section 1231 or capital gain.
Depreciation is a method of allocating the cost of an asset over a particular time period, notes About.com This approach reduces the cost basis of an asset. The eventual sale of the associated asset results in a gain that is now greater since the depreciation reduced the cost basis. Taxpayers must classify the portion of the gain that is recapturing depreciation as ordinary income. The remaining gain is a more favorable capital gain. Taxpayers should keep detailed books and records to accurately classify gains on asset sales.
Particular rules apply to residential property subject to depreciation recapture, notes About.com. With rental property, any passive activity losses from previous years become deductible in full when selling the property. This tax treatment helps offset some of the depreciation recapture tax. Moreover, rental properties can quality as like-kind exchanges which defers the tax gain treatment for the rental asset. The Internal Revenue Service website discusses depreciation recapture and associated tax items in detail in Publication 523, Publication 527 and Publication 544.