Depreciation reduces your cost basis on assets, says CFP and CPA Howard Hook. This is done so that when the asset is either sold or disposed of, the portion depreciated is not deducted again.
A taxpayer who sells their primary residence must reduce their original cost plus improvements by the amount of depreciation taken on the business use of the home.
For example, Bob sells his home for $500,000. Bob purchased the home in 1995 for $250,000. In the past, he had taken $50,000 of depreciation deduction against the portion of the home used for business. Therefore, his adjusted basis in the home is $250,000 minus $50,000, or $200,000. This is called "recapture" because the previous depreciation is being "recaptured" at sale. This is taxed at ordinary income tax rates, and the balance of the gain is taxed at capital gain rates.
So in this example, Bob had a $300,000 gain ($500,000 minus $200,000). Of the $300,000, $50,000 is taxed at ordinary income tax rates and $250,000 would be subject to capital gains tax rates.
However, primary residences carry with them an exclusion of gain of $250,000 ($500,000 if married filing jointly) if the owner meets certain tests. Hook says the IRS does not require that the gain be allocable to business and personal uses. Instead, it can be allocable to the primary residence exclusion. The exception is that the portion of the recaptured depreciation cannot be excluded. In Bob's example, the $250,000 of gain could be excluded under the qualified primary residence exclusion, and Bob would still have to recapture $50,000 of the depreciation.