When you sell a fully depreciated asset, the entire amount you receive is taxable gain, and most of it is taxed at ordinary income rates rather than the lower long-term capital gains rates. The reason is mechanical: depreciation has driven the asset’s adjusted basis to zero, so there is nothing to subtract from the sale price. On top of that, depreciation recapture rules force you to pay back the tax benefit of those earlier deductions at your regular marginal rate. Getting the recapture math, the five-year lookback, and the reporting sequence right is what separates an expected tax bill from an unpleasant surprise.
How the Gain Is Calculated
The formula is straightforward. Amount realized minus adjusted basis equals gain. A fully depreciated asset has a basis of zero, so the amount realized is the gain.
The amount realized is not simply the sticker price on the sale. Reduce it by selling expenses such as broker commissions, legal fees, and closing costs before you calculate gain. Equipment sold for $10,000 with $600 in broker fees produces an amount realized of $9,400, and a gain of $9,400.1Internal Revenue Service. Publication 544 – Sales and Other Dispositions of Assets
If the sale price happens to exceed what you originally paid for the asset, the entire amount is still gain. The portion up to your original cost then runs through the depreciation recapture rules; anything above original cost may qualify for capital gains treatment through Section 1231.
Equipment and Vehicles: Section 1245 Recapture
Section 1245 covers most tangible personal property used in a business: machinery, vehicles, office furniture, computers, and specialized tools.2Office of the Law Revision Counsel. 26 USC 1245 – Gain From Dispositions of Certain Depreciable Property It also reaches certain tangible property used in manufacturing, production, and transportation.
The rule is aggressive. Gain is taxed as ordinary income up to the full amount of depreciation you claimed. For a fully depreciated asset, that means the entire gain up to the asset’s original cost is ordinary income. Pay $20,000 for a machine, depreciate it to zero, and sell it for $6,000, and all $6,000 is ordinary income taxed at your marginal rate.
Only gain exceeding the original cost escapes ordinary treatment. If that same $20,000 machine sells for $22,000, the first $20,000 is ordinary income and the remaining $2,000 becomes Section 1231 gain, which may qualify for long-term capital gains rates after passing through the netting process described below.
For nearly every fully depreciated piece of equipment, the practical result is that the entire sale price hits your return as ordinary income. That is where owners expecting capital gains treatment get caught out.
Buildings: Section 1250 and the 25% Rate
Real property, including commercial buildings, warehouses, and rental structures, falls under Section 1250.3Office of the Law Revision Counsel. 26 USC 1250 – Gain From Dispositions of Certain Depreciable Realty The treatment is less punishing than Section 1245 but still meaningful.
Buildings placed in service after 1986 use straight-line depreciation. Section 1250 technically recaptures only depreciation claimed in excess of straight-line, so there is usually no “additional depreciation” to tax at ordinary rates. That is not the whole story, though.
A separate category called “unrecaptured Section 1250 gain” fills the gap. It taxes the total straight-line depreciation you claimed at a maximum federal rate of 25%.4Internal Revenue Service. Treasury Decision 8836 – Unrecaptured Section 1250 Gain The 25% rate applies to the lesser of your recognized gain or the total depreciation taken. Gain above the total depreciation is Section 1231 gain, potentially eligible for long-term capital gains rates.
Say you fully depreciated a commercial building that originally cost $500,000 and sold it for $100,000. The entire $100,000 is unrecaptured Section 1250 gain, taxed at up to 25% federal.
Allocating Between Land and Building
Real property sales almost always include land, and land is not depreciable. Only the portion of the sale price allocated to the building is subject to recapture.5Internal Revenue Service. Publication 551 – Basis of Assets
The standard approach is to allocate based on the relative fair market values of land and building at the time of sale. If reliable appraisals aren’t available, the IRS accepts assessed values from local property tax records as a reasonable proxy. Getting this allocation wrong is one of the easier ways to overpay: every dollar attributed to the building is a dollar subject to the 25% rate.
Section 179 and Bonus Depreciation Get Recaptured Too
If you used Section 179 expensing or bonus depreciation to write off an asset quickly, those deductions count as depreciation for recapture purposes.6Internal Revenue Service. Instructions for Form 4562 – Depreciation and Amortization The full amount you deducted is part of what gets recaptured as ordinary income under Section 1245 when you sell.
This trips up owners who expensed an asset upfront, enjoyed the immediate deduction, and then forgot about it years later. There is no special break for having chosen an accelerated method. A separate rule also requires partial recapture of a Section 179 deduction, without any sale, if business use of the asset drops to 50% or below before the end of its recovery period.
The Five-Year Lookback That Can Undo Capital Gains Treatment
Section 1231 gains and losses from business property sales must be netted together each year. A net gain is treated as long-term capital gain; a net loss is treated as ordinary loss. That asymmetry is deliberately good for taxpayers, and Congress attached a check on it.
The check is a five-year lookback. If you had net Section 1231 losses in any of the previous five tax years that were treated as ordinary losses, your current-year net Section 1231 gain is recharacterized as ordinary income to the extent of those prior losses.7Internal Revenue Service. Instructions for Form 4797 – Sales of Business Property The idea is that you can’t take an ordinary loss on the way down and then capital gains treatment on the way up for the same class of assets.
Business owners who sold property at a loss a few years ago, deducted the loss against ordinary income, and now expect capital gains rates on a new sale often discover the lookback the hard way.
Selling to a Related Party Makes It Worse
Section 1239 treats the entire gain on a sale of depreciable property between related parties as ordinary income, not just the recapture portion.8Office of the Law Revision Counsel. 26 USC 1239 – Gain From Sale of Depreciable Property Between Certain Related Taxpayers Related parties include a person and any entities they control, a taxpayer and a trust where they are a beneficiary, and an executor selling to an estate beneficiary.
For a fully depreciated asset, Section 1239 usually doesn’t change much because the recapture rules would already make most of the gain ordinary income. What it does eliminate is any possibility of Section 1231 capital gain on the excess above original cost.
Installment Sales Don’t Delay the Recapture
Spreading the payments over multiple years does not spread the recapture. The tax code requires all depreciation recapture income to be recognized in the year of sale, regardless of when payments arrive.9Office of the Law Revision Counsel. 26 USC 453 – Installment Method
Sell a fully depreciated machine for $30,000 payable over three years, and you report the entire recapture amount as ordinary income in year one, even though you have only collected $10,000. Only gain above the recapture amount can be spread over the installment period. For real property, unrecaptured Section 1250 gain is taken into account before any remaining capital gain during the installment period.10eCFR. 26 CFR 1.453-12 – Allocation of Unrecaptured Section 1250 Gain Reported on the Installment Method
Like-Kind Exchanges: Real Property Only
A Section 1031 like-kind exchange is the main way to defer depreciation recapture on real property. Exchange a fully depreciated building for another qualifying real property of like kind, and recognition of both the recapture gain and any capital gain is deferred. The prior depreciation carries over to the replacement property, so recapture is postponed rather than erased.
Since the Tax Cuts and Jobs Act took effect in 2018, like-kind exchanges are limited to real property. Equipment, vehicles, and other personal property no longer qualify. Those assets face Section 1245 recapture at sale with no deferral option. The exchange must also meet strict identification and closing deadlines, and if the replacement property contains less depreciable property than what you gave up, some recapture can still be triggered.
Net Investment Income Tax and State Tax Add Layers
Gain from the sale may also be hit with the 3.8% Net Investment Income Tax. The surtax applies to individuals with modified adjusted gross income above $200,000 (single) or $250,000 (married filing jointly), and those thresholds are not indexed for inflation.11Internal Revenue Service. Questions and Answers on the Net Investment Income Tax
If you actively run the business that owned the asset, the gain generally is not subject to NIIT. A passive investor in a partnership or S corporation, or an owner of rental real estate, can face the 3.8% on top of recapture tax and state income tax.
Most states with an income tax do not offer a preferential rate for capital gains or a separate recapture rate. Gain flows to the state return at your regular state rate, ranging from zero in states without an income tax to over 13% at the top end.
Reporting the Sale on Form 4797
Every sale of depreciated business property runs through Form 4797, Sales of Business Property. The form handles recapture, the Section 1231 netting, and the routing of each piece of the gain to the right line on your return.12Internal Revenue Service. About Form 4797 – Sales of Business Property
You fill out the three parts out of order:
- Part III is where you start. Enter the sale price, dates, original cost, and total depreciation. The form calculates how much gain is ordinary income under Sections 1245 and 1250, and that amount transfers to Part II.7Internal Revenue Service. Instructions for Form 4797 – Sales of Business Property
- Part II collects the ordinary income and sends the total to your main return.
- Part I handles the Section 1231 netting. Any gain not recaptured as ordinary income lands here, gets netted against other Section 1231 items for the year, and passes through the five-year lookback. A net Section 1231 gain transfers to Schedule D as long-term capital gain.
For real property, unrecaptured Section 1250 gain is identified specifically on Form 4797 and flows to the Schedule D worksheet, which applies the 25% cap. Schedule D only enters after Form 4797 has separated ordinary income from capital gain. Reporting the sale directly on Schedule D and skipping Form 4797 will produce the wrong recapture number and is likely to be flagged.
Installment sales add Form 6252, which coordinates with Form 4797 to accelerate the recapture into the year of sale while spreading the remaining gain across the payment years.