I will try to make a very brief example.
Suppose you have a house worth $100,000, and 10% of the house is used for business. The value of the house used for business is $10,000, which must be put in service as a business asset and depreciated over 39 years. That’s roughly $250 per year. (I am oversimplifying several factors, hopefully my colleagues won’t nitpick me.)
That means that for each year the home is used in business, the business owner deducts $250 of the value of the home as a business expense, reducing their business taxable profit and reducing the amount of business tax they have to pay. That depreciation also reduces the cost basis of the home. Cost basis is, roughly speaking, the amount of already-taxed dollars that are invested in something. If you invested $100,000 in the house, and then are taking a $250 per year tax deduction, you must reduce the cost basis of the house.
Suppose you then sell the house for $200,000. Without the business use, you would have $100,000 of capital gain. If you had 10 years of business use, your cost basis would be reduced from $100,000 to $97,500, so your capital gain would be $102,500. That first $2500 of capital gain is called depreciation recapture, and it is taxable. Then the remaining $100,000 of capital gains may or may not be taxable depending on whether the person qualifies for the exclusion on their personal home.
To oversimplify even further. Depreciation is an allowance for the value of property that is “used up“ in business. If you sell property for more than you paid for it, then you are recovering the value that you previously claimed was “used up.“ Since you are recovering the value of a previous tax deduction, you have to pay tax on that recovered value.
Because of concepts like inflation and the future value of money, it is generally best to take the present tax deduction, even if that means paying the same amount of tax back in the future.
