Depreciation is a powerful tax deduction. For personal property used in a business—think equipment, computers, furniture, machinery etc.—current tax law allows for depreciation to be claimed at a very accelerated pace. In many cases 100% of an asset’s cost can be depreciated in the year of purchase. For real property used in a business or investment, depreciation can reduce your tax bill even if the real estate value increases! However, the depreciation that reduces your tax bill today may increase your tax liability in the future. This drawback, called “depreciation recapture,” is worth understanding and planning for.
Business assets held longer than a year generally must be capitalized in the year the asset is placed in service. Rather than claiming an immediate expense on the income statement, capitalizing moves the asset to the balance sheet, from where it is expensed over time using depreciation.
Accumulated depreciation increases as depreciation expense is claimed each year. As a result, the asset’s carrying value—cost less accumulated depreciation—decreases over time. And as an asset’s carrying value decreases, its taxable gain upon sale increases. In its basic form, taxable gain equals sale proceeds minus the asset’s tax carrying value (i.e. tax basis).
The tricky part about depreciation is that when the asset is sold at a gain, “depreciation recapture” can kick in. Depreciation recapture generally refers to the portion of gain caused by accumulated depreciation. The disadvantage is that depreciation recapture is taxed at higher rates than normal capital gains.
When personal property is sold, depreciation recapture is recognized to the extent of accumulated depreciation or total gain, whichever is less. This is referred to as Sec. 1245 recapture, based on the applicable tax code section. Gain in excess of accumulated depreciation is generally subject to the more favorable capital gains rates under Sec. 1231.
Real property is treated a little differently. When straight-line depreciation is used, frequently the case with real estate, gain from straight-line depreciation is treated as “unrecaptured” Sec. 1250 gain. When accelerated depreciation is used for real property—for example bonus depreciation taken on qualified improvement property—only the difference between accelerated and straight-line depreciation is subject to depreciation recapture. And as with personal property, gain in excess of accumulated depreciation is subject to capital gains rates under Sec. 1231.
Depreciation recapture is taxed at ordinary rates, a maximum 37% for most business types (non-C corporations). Unrecaptured Sec. 1250 gain is taxed at a maximum 25% rate. Capital gains are taxed at a maximum 20% rate. Therefore strategies to characterize gain as capital gain, rather than depreciation recapture, should be considered.
|Cost of Real Property||$100,000|
|Total Accumulated Depreciation||$15,000|
|Depreciation Deducted Under an Accelerated Method Exceeding Straight-line Method||$5,000|
|Adjusted Cost Basis (Original Cost Less Depreciation)||$85,000|
|Total Gain Realized||$35,000|
|Depreciation Recapture – 37% max ordinary rate (non-C corporation assets)||$5,000|
|Unrecaptured Depreciation – 25% max capital gains rate||$10,000|
|Capital Gain – 20% max capital gains rate||$20,000|
These are just the basics, as the rules in this area can be complex depending on your situation. If you are considering selling business assets, please contact your L&B professional (858) 558-9200 with any questions.