The tax treatment of depreciation recapture on the sale, trade-in, or other disposition of a business or mixed-use vehicle is governed primarily by Internal Revenue Code §1245 and related Treasury Regulations. Understanding how recapture works is important, as it can significantly affect the tax outcome when a vehicle is disposed of.
1. What is Depreciation Recapture?
When a vehicle used in a trade or business is sold or otherwise disposed of, the IRS requires taxpayers to “recapture” depreciation previously claimed (or allowable). Depreciation recapture means that the portion of any gain attributable to prior depreciation deductions is taxed as ordinary income, rather than at preferential capital gains rates.
This rule prevents taxpayers from benefiting twice. By first reducing ordinary income through accelerated depreciation (including Section 179 and bonus depreciation), and later by recognizing that same amount as capital gain upon sale.
2. How Depreciation Recapture is Calculated
A. Purchase and Deduction (Year 1)
- You purchase vehicle for $40,000
- You elect to deduct $25,000
- Your adjusted basis becomes $15,000 ($40,000 – $25,000)
B. Sale
- You sell the machine for $20,000
- Gain Calculation: Sales Price ($20,000) – Adjusted Basis ($15,000) = $5,000 Total Gain
C. Depreciation Recapture:
- Depreciation recapture is limited to the lesser of the total depreciation taken or the actual gain on sale. Therefore, the $5,000 gain is “recaptured”.
- This $5,000 gain is taxed at your ordinary income tax rate (section 1245 gain), not capital gains rates (Section 1231 gain), because the tax benefit was received through immediate deductions.
- Under IRC §1245(a), any gain on disposition up to the amount of depreciation previously allowed or allowable must be recaptured as ordinary income.
- Section 1031 gain at long-term capital gains treatment would qualify when gain realized exceeds total depreciation taken.