Understanding Tax Terms: Depreciation Recapture

Understanding Tax Terms: Depreciation Recapture

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.

* This example is simplified for clarity. Actual depreciation methods used will vary from this example. The ordinary income must be claimed on your tax return and is caused because of the depreciation taken in prior years. This illustrates the recapture of prior period depreciation.

When does depreciation recapture occur?

Look for the possibility of depreciation recapture when:
1. You sell rental property
2. You sell your home that you have used as a home office
3. You sell any property used within a small business

Warning: Understand the allowed or allowable trap

One of the land mines surrounding depreciation recapture rules is the concept of “allowed or allowable.” When calculating whether you owe deprecation recapture related taxes, the tax code requires that you adjust for depreciation whether or not you actually took the depreciation expense in prior years. So if you have assets that should be depreciated on your tax return, but are not, please call for a review of your situation.

What you should know

First and foremost, many unsuspecting landlords forget that years of depreciation on their property can impact their tax obligation when the property is sold. This can occur even if the sales price is less than what they paid for the property.

Secondly, the tax code applies different tax rates on ordinary income versus depreciation recapture versus long-term capital gains. The maximum tax rates on each are noted here:

Personal income tax: 37.0%
Depreciation recapture: 25.0%
Long-term capital gains: 20.0%
(excludes the impact of possible Affordable Care Act surtax)

Unfortunately, the tax laws in this area are fairly complex. The amount due can be impacted by;
• Different depreciation methods
• Use of Section 179 and bonus depreciation rules
• Improvements made to property
• Like-kind exchange rules
• Asset class designations

Thankfully, you do not need to understand the complexities surrounding depreciation recapture rules. You simply need to know they exist and ask for assistance.
( Article From The newsletter of Gary Carter)

Have a question? Contact Gary Carter,GW Carter LTD, CPA

Gary Carter, President of GW Carter, Ltd., was a tax professor at the University of Minnesota’s Carlson School of Management and the Associate Director of the Carlson School’s Master of Business Taxation Program until June, 2010. He received a B.A. in accounting from Eastern Washington University in 1977, a Master of Taxation degree from the University of Denver in 1980, and a Ph.D. in taxation from the University of Texas at Austin in 1985. Early in his career he worked as a revenue agent for the State of Alaska, and later in public accounting for both a regional CPA firm and a Big Four Firm. His current practice was started in 1999. He has conducted tax seminars on various tax topics and has published several books on taxation.

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2 comments on “Understanding Tax Terms: Depreciation Recapture

  • Section 1250 property includes commercial buildings (MACRS 39-year real property) and residential rental property (MACRS 27.5-year residential rental property). If section 1250 property is depreciated using the straight-line method (or is fully depreciated because the depreciation period has ended) there is no excess depreciation to recapture.

  • If section 1250 property (such as 39 year commercial or 27.5 residential) is depreciated using the straight-line method (or if the property is fully depreciated because the depreciation period has ended) there is no excess depreciation to recapture.

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