Understanding Proposed Changes to Depreciation Recapture

The U.S. tax code has always had complexities, especially when it comes to how gains from the sale of depreciable property are treated.

A recent proposal included in President Biden’s greenbook aims to address these complexities and ensure a fairer tax system by modifying the rules around depreciation recapture, particularly for real estate.

Here’s what you need to know about the proposed changes and their implications.

As we near the 2024 U.S. Presidential Election, it is important to track all candidates’ tax proposals. We have created a tracker so you can do just that.

Current Law: How Depreciation and Gains Are Treated

Under the current law, when a taxpayer sells an asset used in a trade or business, they must recognize any gain or loss.

This gain or loss can be classified as either ordinary income or capital gains, depending on several factors.

For most real estate transactions, gains that are due to depreciation deductions taken during the ownership period (known as depreciation recapture) are treated differently than other types of gains:

• Section 1245 Property: This category includes personal property and some specific real properties, like those subject to special expensing rules. The recapture of depreciation on these properties is treated as ordinary income up to the total amount of depreciation taken.
• Section 1250 Property: This typically includes buildings and other structural components. For these properties, only the depreciation deductions exceeding straight-line depreciation are recaptured as ordinary income, with the rest potentially being taxed at the more favorable capital gains rates.

This distinction has allowed real estate owners to benefit from lower tax rates on certain gains, effectively converting what could be considered ordinary income into capital gains, which are often taxed at lower rates.

Reasons for the Proposed Change

The proposed change seeks to address what is seen as a disparity in the tax treatment of gains from depreciable real property, particularly buildings and similar assets (Section 1250 property).

Currently, real estate owners can take advantage of depreciation deductions, reducing their taxable income, and later sell the property at a gain taxed at lower capital gains rates. This situation can be seen as a tax subsidy, allowing for a conversion of ordinary income (subject to higher tax rates) into capital gains (subject to lower rates).

The proposal argues that this system provides an undue benefit, especially to noncorporate taxpayers involved in real estate, thus reducing the overall progressivity of the tax system.

By ensuring that gains attributable to depreciation deductions are fully recaptured as ordinary income, the proposal aims to level the playing field and eliminate this tax advantage.

The Proposal: Key Changes

Under the new proposal, any gains realized from the sale of Section 1250 property held for more than one year would be recaptured as ordinary income, to the extent of the depreciation deductions taken after the proposal’s effective date.

This change would not impact noncorporate taxpayers with an adjusted gross income (AGI) below $400,000 ($200,000 for married individuals filing separately).

Additionally, partnerships and S corporations would be required to calculate and report gains and losses at the entity level, ensuring that all owners are taxed appropriately under the new rules.

Implications and Next Steps

The proposal, if enacted, would take effect for depreciation deductions on Section 1250 property starting in taxable years after December 31, 2024. This means real estate owners and investors need to be aware of how these changes might impact their tax liabilities, particularly for properties they plan to sell after this date.

By aligning the tax treatment of gains from real estate more closely with other types of income, this proposal aims to simplify the tax system and eliminate what is seen as an unfair advantage for certain taxpayers. As with any proposed tax legislation, it’s essential for taxpayers to stay informed and consider the potential impacts on their financial planning strategies.