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.
Defined
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:
- You sell rental property
- You sell your home that you have used as a home
office
- 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.
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