When a taxpayer sells an asset for a gain after taking deductions for depreciation, depreciation recapture is used to tax the gain. Because the taxpayer received a deduction from ordinary income for the depreciation of the asset, any gain the taxpayer receives, up to the depreciation amount, must be included as ordinary income to offset the earlier deduction.
For example, the widget discussed above had an original basis of $1,000. The taxpayer took $400 worth of depreciation deductions from his ordinary income over the course of four years. At the end of those four years, the taxpayer’s adjusted basis in the asset had changed to $600. If the taxpayer then sells the asset for $700, then he would realize a gain of $100. Because he received depreciation deductions, he would be required to include the $100 gain as part of his ordinary income. This is a depreciation recapture. However, if taxpayer instead sells the property for $1200, because his recomputed basis is $1000, $400 of the gain is taxed as ordinary income and $200 is taxed at the more favorable capital gains tax rate.