One of the more unpleasant surprises that can hit a taxpayer occurs when you sell personal property, rental property or assets from your small business. This tax surprise is often associated with depreciation recapture rules.
Depreciation recapture refers to reducing the cost of an asset sold by prior period’s depreciation expense to determine whether taxes are owed on the sale of an asset and to determine the type of tax that must be paid on the sale of the asset.
When you have business property with a useful life of over one year, you often have the ability to deduct part of the cost of that property over the estimated useful life (recovery period) of that property. The most common users of these depreciation rules are small businesses and rental property owners.
When the asset is later sold the IRS wants you to determine if any tax is due as either ordinary income or as a capital gain.
A simplified example: Assume you run a small business out of your home. You purchase a new computer used 100% by your small business. The cost of the computer is $3,500. IRS rules determine you may recover the cost of this type of asset over five years. So each year you can deduct $700 as depreciation (1/5 of the cost of the computer assuming straight-line depreciation is used) on your business tax return.
Next assume the computer was sold at the end of year three for $2,000. This will result in a taxable event that includes depreciation recapture.