When assets are sold, the difference between selling price and depreciated costs is gain subject to tax. For tax purposes, there are two types of gain: ordinary and capital.

Ordinary gain is taxed at the taxpayer's highest marginal rate, and capital gain is taxed at the taxpayer's highest marginal rate up to 28%. The highest marginal rate for any individual taxpayer is 39.6% plus perhaps self-employment tax.

For section 1245, assets which are primarily assets other than buildings, the gain attributable to prior year's depreciation is "recaptured" as ordinary income. The balance of the depreciation is capital gain. For example, if someone owns a $20,000 business machine which has been depreciated $12,000, his "adjusted basis is $8,000. If he sells the equipment for $10,000, he has ordinary income of $2,000. Alternatively, if he sells the equipment for $25,000, his ordinary income (Depreciation Recapture) is $12,000 and his capital gain is $5,000.

If a taxpayer sells real estate which was depreciated using the straight-line method, there is no depreciation recapture. If an accelerated depreciation method was used, the rules are complex, and there may be depreciation recapture.

If assets subject to recapture are the object of a tax-free exchange, depreciation recapture is only recognized to the extent of boot received. If no boot is received, there is no depreciation recapture.

In private letter ruling 9447008, an automobile rental company, established a master exchange agreement with an intermediary. After three years, when the automobiles were substantially depreciated, the rental company would assign the sales agreement with an auction company to the intermediary for subsequent sale. After the old cars were sold, the rental company would identify a replacement vehicle for the intermediary to acquire as part of a tax-free exchange. The master exchange agreement provided for a continuous exchange of old vehicles for new vehicles without depreciation recapture.