What is Depreciation Recapture?

Sometimes assets appreciate in value, and sometimes they depreciate. When this happens, a business owner can write the depreciation off against their income. But if they sell the asset, Uncle Sam is going to recapture part of that depreciation.

Frequently Asked Questions About Depreciation Recapture

1. What is Depreciation Recapture?

2. How Does Recapture of Depreciation Work?

3. How is Depreciation Recapture Taxed?

4. How is Depreciation Recapture Calculated?

5. What Assets Are Subject to Depreciation Recapture?

6. Can you Avoid Depreciation Recapture Taxes?

7. How Much Can You Depreciate Yearly?

Depreciation recapture is not just a concept for tax professionals to worry about. The nuances and tax implications are an important consideration for any real estate investor or business owner. This is because a property owner who makes the accounting choice to depreciate property from its original fair market value is enjoying a great annual tax deduction that they will eventually need to pay back in the form of a recapture tax. As they say: all good things must come to an end—and that includes the tax benefits of depreciable property.

One could say that the purpose of applying an ordinary tax income rate to the sale of investment property (plus, in some instances, capital gains taxes) is to help the Internal Revenue Service recoup a portion of the taxable income they did not initially receive because of a depreciation deduction applied to gross income. A depreciation recapture tax is the remedy the internal revenue code uses to offset some of its losses and ensure the government gets paid.

As we answer some of these frequently asked questions, keep in mind that depreciation recapture doesn’t just apply to investments and business property; it applies to personal property as well. For most individuals, the only applicable case of depreciation recapture will only occur when they sell their personal residence.

Frequently Asked Questions About Depreciation Recapture

1. What is Depreciation Recapture?

Depreciation recapture allows the IRS to collect taxes on the sale of an asset that a business had previously used to offset its taxable income through wear, tear, and operating expenses. If that sounds complicated, it is—but we’ll provide examples later.

As mentioned, it does also apply to personal property. However, writing off the depreciation of property that isn’t real property usually only applies to a business that has assets with operational expenses.

2. How Does Recapture of Depreciation Work?

Monetary gain from the sale of said asset will be taxed as ordinary income, so the exact rate will depend on the income of the business. In most cases, the taxable amount is less than you might expect because the asset has depreciated over the years (think of machinery or a vehicle).

In some cases, however, the market value of the asset may have appreciated (think real estate or collectibles), even though it carried operating expenses. In these cases, the accumulated depreciation that was written off is taxed as income, and any profitable gain beyond that is taxed at the capital gains rate.

3. How is Depreciation Recapture Taxed?

The exact amount of taxes to be paid on depreciation recapture will depend on a few factors, including the cost basis, the adjusted cost basis, the gross annual income of the business itself (which determines its tax bracket) and whether or not the sale of the asset resulted in any profit beyond the original cost basis (which would be subjected to capital gains taxation).

As you can see, there are a number of moving factors that make this question difficult to answer with a one size fits all approach. The taxation will also depend on the type of asset in question, and whether it is real property (land and improvements) or pecuniary property (like machinery or vehicles).

4. How is Depreciation Recapture Calculated?

The first thing that must be established is the original cost basis of the item. The next piece of requisite information is the annual depreciation. There are a number of ways to calculate this, but one of the most common ways is the?straight line method. This basically takes the original cost of the asset, it’s value at the end of its usable life, and then divides that dollar amount by the number of years it will be in service. The end number is going to be the accumulated depreciation of the asset.

If the asset is sold for a profit, that profit is calculated by examining its adjusted cost basis (basically its value at the time of the sale, according to its depreciation, not its value at the time of its purchase) and subtracting that from the dollar amount of the sale to find its realized gain.

Between the realized gain and the accumulated depreciation, the taxes for depreciation recapture are applied to the smaller dollar amount. If, however, the asset was sold for more than it was purchased, the entirety of the depreciation is recaptured and then the profit is taxed at the capital gains rate.

Read more about how to write the depreciation off against your income.

If your business or real estate investment is dealing with depreciation recapture taxes, it’s a smart idea to work with a tax expert to create a plan for reducing your tax liabilities.

A great first step toward doing so would be to sign up for our?Tax and Asset Protection Workshop. Not only will you learn how to utilize tried and true tax strategies to save money, but we’ll also help you create a plan to protect your assets for many years to come. Don’t leave your investments at risk any longer—sign up today!