How Are Capital Gains Calculated on Real Property Depreciation?

Depreciation is a tax deduction that accounts for wear and tear on your investment property. Although depreciation offers a tax break while you own real property, it increases your overall capital gain when you sell it. A capital gain is the difference between your property’s sales price and its adjusted basis, which is its original cost minus accumulated depreciation. The process of paying taxes on previously deducted depreciation is called depreciation recapture. You typically must pay a higher tax rate on the portion of your capital gain that comes from depreciation recapture than on the other portion.

Step 1

Determine the price for which you bought and sold an investment property. For example, assume you bought an office building for $1 million and sold it for $1.4 million.

Step 2

Subtract the total depreciation deductions you were allowed to take while you owned your property from the property’s original cost to determine your adjusted basis. Even if you didn’t deduct some depreciation while you owned the property, you must include all the depreciation the Internal Revenue Service allowed you to take in your calculation. In this example, assume you were allowed to take $100,000 in depreciation while you owned the property. Subtract $100,000 from $1 million to get a $900,000 adjusted basis.

Step 3

Subtract your adjusted basis from your selling price to determine your total capital gain. In this example, subtract $900,000 from $1.4 million to get a $500,000 capital gain.

Step 4

Subtract your accumulated depreciation from your total capital gain to determine the portion that is a regular capital gain, which typically receives favorable tax treatment. The portion from accumulated depreciation is your depreciation recapture, on which you typically pay a higher rate. Concluding the example, subtract $100,000 from $500,000 to get $400,000. This means that $400,000 of your total capital gain will be taxed as a regular capital gain and $100,000 will be taxed as depreciation recapture.

Tip

  • The specific tax rates you must pay on depreciation recapture and on your remaining gain depend on your particular tax bracket among other factors. Consult an accountant to determine how much tax you owe on the sale of your specific investment property.

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