What Happens When You Sell a Fully Depreciated Asset?

When you sell a fully depreciated asset, nearly every dollar you collect is taxable, and most of it is taxed as ordinary income rather than at the lower long-term capital gains rates. The asset’s adjusted basis has been written down to zero through years of depreciation deductions, so there’s nothing left to offset the sale price. The IRS then treats the gain primarily as “depreciation recapture,” which claws back the tax benefit those earlier deductions gave you. The exact rate depends on what you sold, who you sold it to, and what your Section 1231 history looks like over the last five years.

How the Gain Is Calculated

The math is short. Take the amount realized from the sale and subtract the asset’s adjusted basis. For a fully depreciated asset, the adjusted basis is zero, so the amount realized is the gain.

Amount realized isn’t the raw sale price. You reduce it by selling expenses such as broker commissions, legal fees, and closing costs. Sell equipment for $10,000 and pay $600 in broker fees, and your amount realized (and gain) is $9,400.¹

If you scrap, abandon, or give the asset away for nothing, there is no gain to report. Amount realized is zero, basis is zero, and the two match.

What drives the tax bill isn’t the size of the gain so much as how it’s characterized. Characterization is where recapture takes over.

Equipment and Other Personal Property: Section 1245

Section 1245 covers most tangible personal property used in a business: machinery, vehicles, office furniture, computers, specialized tools, and certain other property used in manufacturing, production, and transportation.²

The recapture rule is aggressive. Gain is treated as ordinary income up to the full amount of depreciation you claimed. For a fully depreciated asset, that ceiling is the original cost. Buy equipment for $20,000, depreciate it to zero, sell it for $6,000, and all $6,000 is ordinary income taxed at your marginal rate.²

Only gain above the original cost escapes ordinary income treatment. If that same $20,000 machine sold for $22,000, the first $20,000 is ordinary income and the remaining $2,000 is Section 1231 gain, which may qualify for long-term capital gains rates after netting and the lookback rule described below.

For practical purposes, if you sell a fully depreciated piece of equipment for anything less than what you paid for it, the entire sale price lands on your return as ordinary income. This is where business owners who expected capital gains treatment get the biggest surprise.

Buildings and Real Property: Section 1250

Real property, including commercial buildings, warehouses, and rental structures, is covered by Section 1250.³ The treatment is softer than Section 1245 but still costs real money.

Buildings placed in service after 1986 use straight-line depreciation. Section 1250 recaptures only depreciation claimed in excess of straight-line, so for most modern buildings there is no “additional depreciation” to recapture as ordinary income under Section 1250 itself.³

A separate category, “unrecaptured Section 1250 gain,” picks up the slack. It equals the total straight-line depreciation claimed, and it is taxed at a maximum federal rate of 25%.⁴ The 25% rate applies to the lesser of the gain recognized or the total depreciation taken. Anything above the total depreciation is Section 1231 gain and can still qualify for long-term capital gains rates.

Fully depreciate a commercial building that originally cost $500,000, then sell it for $100,000, and the full $100,000 is unrecaptured Section 1250 gain subject to the 25% ceiling.

Allocating Between Land and Building

When you sell real property you’re almost always selling the land along with it, and land isn’t depreciable. The sale price has to be split between the two, and only the building portion runs through recapture.⁵

The usual method is to allocate based on relative fair market values at the time of sale. Without reliable appraisals, the IRS accepts assessed values from property tax records as a reasonable proxy.⁵ Every dollar wrongly attributed to the building is a dollar taxed at the 25% recapture rate instead of flowing to the land side, so the split is worth getting right.

Section 179 and Bonus Depreciation Get Recaptured Too

If you expensed an asset upfront using Section 179 or bonus depreciation, those deductions are part of the total depreciation that gets recaptured when you sell. The IRS treats them as part of the total depreciation allowed or allowable for the property.⁶

The common mistake is writing an asset off in year one, forgetting about it, and then being surprised years later when the whole sale price comes back as ordinary income under Section 1245. There is no favorable treatment for having used an accelerated method; if anything, the full write-off guarantees that recapture reaches the entire original cost.⁶

Section 1231 and the Five-Year Lookback

Any gain that exceeds the depreciation recapture amount is Section 1231 gain. Section 1231 requires netting all business-property gains and losses for the year. A net gain is treated as long-term capital gain; a net loss is treated as an ordinary loss.

The catch is the five-year lookback. If you had net Section 1231 losses in any of the previous five tax years that were deducted as ordinary losses, your current-year net Section 1231 gain is recharacterized as ordinary income up to the amount of those prior losses.⁷ You don’t get ordinary loss treatment on the way down and capital gain treatment on the way up for the same class of property.

If you sold business property at a loss a few years back and wrote it off against ordinary income, check that history before assuming any portion of your current sale will get capital gains rates.

Related-Party Sales Are Worse

Sell a depreciable asset to a related person or entity and Section 1239 kicks in. The entire gain is ordinary income, not just the recapture portion.⁸

Related parties include a person and any entities they control, a taxpayer and a trust in which they are a beneficiary, and an estate executor selling to a beneficiary. The point of the rule is to stop a taxpayer from reporting capital gain on a sale to a controlled entity while the buyer picks up a fresh depreciable basis to generate new ordinary deductions.⁸

For a fully depreciated asset, Section 1239 rarely changes the recapture result (most of the gain is already ordinary income), but it closes off any Section 1231 capital gain on the sliver that exceeds original cost.

Installment Sales Don’t Delay Recapture

Spreading payments over several years does not spread the recapture tax. The code requires all depreciation recapture income to be recognized in the year of sale, no matter when the cash arrives.⁹

Sell a fully depreciated machine for $30,000 payable over three years and the entire recapture amount is ordinary income in year one, even if you’ve only collected $10,000. Only gain exceeding the recapture amount can be reported on the installment method.⁹ On real property, unrecaptured Section 1250 gain is taken into account before any remaining capital gain over the installment period.¹⁰

Like-Kind Exchanges Can Defer, but Only for Real Property

A Section 1031 like-kind exchange is the main tool for deferring depreciation recapture on a sale. Exchange a fully depreciated building for another qualifying real property and both the recapture and any capital gain can be deferred. The deferred depreciation carries over to the replacement property, so recapture is postponed, not forgiven.

Since the Tax Cuts and Jobs Act took effect in 2018, Section 1031 is limited to real property. Equipment, vehicles, and other personal property no longer qualify, which means Section 1245 recapture on those items has to be paid at the time of sale with no deferral available. Even for real property, an exchange that includes less depreciable property than what you gave up can still trigger some recapture.

The 3.8% Surtax and State Taxes

Gain from the sale can also attract the 3.8% Net Investment Income Tax if your modified adjusted gross income is over $200,000 (single) or $250,000 (married filing jointly). Those thresholds are not indexed for inflation.¹¹

NIIT generally doesn’t reach gains from a business you actively run. It does reach gains tied to rental real estate and passive interests in partnerships or S corporations, where the 3.8% surtax layers on top of the recapture tax.¹¹

State income tax is a separate layer. Most states don’t offer a preferential rate for capital gains or recapture; the gain flows through to your state return at the regular state income tax rate, which ranges from zero in states with no income tax to above 13% in the highest-tax states.

Reporting the Sale

Sales of depreciated business property are reported on Form 4797, Sales of Business Property. The form handles the recapture calculation, the Section 1231 netting, and routing each piece of gain to the right place on your return.¹²

Part III of the form calculates how much of the gain is ordinary income under Sections 1245 and 1250. That amount flows to Part II as ordinary income. Any gain above the recapture amount drops to Part I, where the Section 1231 netting and the five-year lookback are applied; a net Section 1231 gain then moves to Schedule D as long-term capital gain.⁷

For real property, unrecaptured Section 1250 gain is identified on Form 4797 and flows to the Schedule D worksheet, where the 25% maximum rate is applied. Installment sales add Form 6252, which coordinates with Form 4797 to accelerate the recapture into the year of sale while the remaining gain is spread across the payment period. Reporting the sale directly on Schedule D without running it through Form 4797 will miscalculate the recapture, and the IRS is likely to catch it.

1
Internal Revenue Service. Publication 544 – Sales and Other Dispositions of Assets
2
Office of the Law Revision Counsel. 26 USC 1245 – Gain From Dispositions of Certain Depreciable Property
3
Office of the Law Revision Counsel. 26 USC 1250 – Gain From Dispositions of Certain Depreciable Realty
4
Internal Revenue Service. Treasury Decision 8836 – Unrecaptured Section 1250 Gain
5
Internal Revenue Service. Publication 551 – Basis of Assets
6
Internal Revenue Service. Instructions for Form 4562 – Depreciation and Amortization
7
Internal Revenue Service. Instructions for Form 4797 – Sales of Business Property
8
Office of the Law Revision Counsel. 26 USC 1239 – Gain From Sale of Depreciable Property Between Certain Related Taxpayers
9
Office of the Law Revision Counsel. 26 USC 453 – Installment Method
10
eCFR. 26 CFR 1.453-12 – Allocation of Unrecaptured Section 1250 Gain Reported on the Installment Method
11
Internal Revenue Service. Questions and Answers on the Net Investment Income Tax
12
Internal Revenue Service. About Form 4797 – Sales of Business Property