Figuring depreciation recapture

Dear Tax Talk,
I will have a capital loss carryover of $129,000 on my 2008 Form 1040, Schedule D ($19,000 long-term and $110,000 short-term) with no current capital gains to offset it, so I will use the $3,000 capital losses limit to offset other income on my 2008 tax return.

In some future year, can I use the balance of the capital loss carryover to offset the depreciation recapture tax on the sale of rental property? Assuming capital gains on the sale is a sure bet, my question is really on the effect, if any, on depreciation recapture.
— Kay

Dear Kay,
You’re on the right track in your thinking. Depreciation recapture on real property is nothing more than a specially taxed type of capital gain. As such, it can be offset by capital losses. Real property used in a trade or business or held out for rental is subject to an allowance for depreciation.

Claiming depreciation is not optional; any unclaimed depreciation is still subject to recapture when the property is sold. Recapture basically means that you must take the prior depreciation deductions back into income. Recapture occurs when a property is sold.

Historically, depreciation was recaptured at the same rate that applied to long-term capital gains. When the long-term capital gains rates were slashed to 20 percent, and later to 15 percent in the early years of this decade, a differential rate was established for recapture. Currently, depreciation recapture is taxed at a maximum of 25 percent.

The tax term applied to depreciation recapture on real property under Modified Accelerated Cost Recovery System, or MACRS, is unrecaptured Section 1250 gain. MACRS is the depreciation system that applies to most property placed in service after 1985.

For most taxpayers, the unrecaptured Section 1250 gain is the lesser of the gain on the sale of the property or the amount of depreciation allowed or allowable. For example, assume you bought a property for $500,000 and were allowed $100,000 in depreciation and the property sold for $550,000. Your gain is $150,000, of which $100,000 is from unrecaptured Section 1250 gain.

If your capital loss carryover is $126,000, your net capital gain would be $24,000. The capital losses exceed the recapture, so the remaining $24,000 is taxed at no more than the maximum preferential rate of 15 percent that applies to long-term capital gains. Depending on your other income for the year, your actual tax could be less than 15 percent.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.