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Depreciation is a benefit at the time you claim it, as it reduces your income and the associated taxes that you pay. But it causes real headaches when you sell the property. All of the depreciation that you claim over the years affects the actual capital gain on the property and also the capital gains tax you will pay. Depreciation does not offset the gain; it can actually increase the amount of capital gains realized on the sale of property.
Cost Basis Reduction
With business personal property or rental real estate, the income-tax filing function of depreciation reduces the cost basis of the property when you dispose of it through sale. Your capital gain on the sale of the item is the selling price minus the cost basis. If you purchased a vehicle for $10,000 and have deducted $9,000 from your income tax for depreciation over several years, your actual cost basis of the vehicle is $1,000. If you sell the car for $2,000, you have a taxable gain of $1,000, which is the amount of the sale that exceeds the cost basis of the property.
With property sold at a capital gain, the gain that is attributable to the depreciation of the property is taxable at a higher rate. Normal capital gains may be taxed at either 15 or 25 percent, depending on your income; you will pay taxes on depreciation recovery at a higher rate -- your normal income rate. The reason for this higher tax is that the depreciation reduced your taxable income when you claimed it, so the recapture of this depreciation increases your taxable ordinary income.
Applying Depreciation to New Property
In some cases, if you use a Section 1301 like-kind exchange to purchase your new property, you may be able to defer the recaptured taxes on the depreciation that you have claimed. This provision applies to real estate. If you sell a property for $100,000, and your cost basis is $90,000 -- reduced by $10,000 in accumulated depreciation -- you can roll the accumulated depreciation into the new property and defer the taxes on the recaptured depreciation until you eventually sell the new property.
Losses Offsetting Gains
Ordinary losses that are not attributable to depreciation also offset capital gains on other property or investments that you sell in the same year. If you sell some residential real estate and realize a $20,000 gain on the property, and you sold some stocks for a $10,000 loss during the same year, your total taxable capital gain would only be $10,000. You can also claim a deduction for a capital loss for the year but only up to a maximum of $3,000 per year.