An investor in a real estate direct participation program sells a depreciated property at a gain. A portion of that gain is attributable to depreciation deductions previously taken against ordinary income. How is that portion of the gain generally taxed upon sale?
- AAs tax-exempt income, since depreciation was already used to offset passive income
- BAs a passive loss carryforward that reduces the investor's other passive income
- CAs long-term capital gain in its entirety, regardless of depreciation taken
- DAs ordinary income through depreciation recapture, with the remaining gain taxed as capital gain
Show answer & explanationAnswer & explanation
Correct answer: D. As ordinary income through depreciation recapture, with the remaining gain taxed as capital gain
When depreciated real property is sold, the portion of the gain equal to the depreciation previously deducted is recaptured and taxed as ordinary income (Section 1250 recapture for real property), while any remaining gain above the original cost basis is taxed at long-term capital gains rates. This prevents investors from converting ordinary deductions into preferential capital gains treatment.
Why the other options are wrong
- A. Incorrect — recaptured depreciation is taxable, not exempt.
- B. Incorrect — recapture is a taxable gain event, not a loss carryforward.
- C. Incorrect — this ignores the recapture rules requiring ordinary income treatment on the depreciated portion.
Depreciation Recapture (Real Estate DPP)
Upon sale of depreciated real property, the portion of gain equal to depreciation taken is taxed as ordinary income (recapture), while remaining gain is taxed as capital gain.
- Applies to real estate and equipment leasing DPPs that used depreciation
- Prevents converting ordinary deductions into capital gain benefits
- Recaptured amount taxed at ordinary income rates, capped for real property under Section 1250 rules
Memory trick: What depreciation gave as a deduction, the IRS takes back as ordinary income at sale.