Depreciation recapture
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Depreciation recapture is the Internal Revenue Service (IRS) procedure for collecting income tax on a gain realized by a taxpayer when the taxpayer disposes of an asset that had previously provided an offset to ordinary income for the taxpayer through depreciation. In other words, because the IRS allows a taxpayer to deduct the depreciation of an asset from the taxpayer’s ordinary income, the taxpayer has to report any gain from the disposal of the asset (up to the recomputed basis) as ordinary income, not as a capital gain. Any gain over the recomputed basis will be taxed as a capital gain in accordance with section 1231 of the Internal Revenue Code (IRC). Does it matter how to classify the gain? Yes, because capital gains are taxed at a lower rate than ordinary income. Depreciation recapture is governed by sections 1245 and 1250 of the IRC.
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[edit] Basis
The starting point for determining when a depreciation recapture will occur is to determine the basis of the asset. There are three different types of basis: original, adjusted, and recomputed basis. The original basis of an asset is usually the value of a taxpayer’s investment in the asset. (See IRC § 1012). When a taxpayer purchases an asset, the original basis is the purchase price, or cost, of the asset. Different factors, including tax deductions for depreciation, can lead to an adjusted or recomputed basis for the asset. (See IRC § 1016 and IRC § 1245(a)(2)(A)). An adjusted basis under IRC 1016 is the original basis of a piece of property plus any increases for improvements to the property or any decreases for depreciation deductions allowed with respect to such property. So, if a taxpayer buys something for $100,000, and takes allowable deductions under IRC 167 for the next 3 years at $5000 per year, his adjusted basis is $85,000. Recomputed basis under IRC 1245(a)(2) basically means, with respect to any property, its adjusted basis recomputed by adding all adjustments reflected on account of deductions allowed or allowable to the taxpayer for depreciation. In the previous example, the taxpayer’s recomputed basis would be $100,000 because you add to the adjusted basis the amounts the taxpayer depreciated. If a taxpayer sells an asset for less than its basis, then the taxpayer has taken a loss. If the taxpayer sells the asset for more than its basis, the taxpayer has experienced a gain. For example, if a taxpayer purchased a widget for $1,000, the original basis of the widget would be $1,000. If the taxpayer sold the widget for $1,500, the taxpayer would experience a capital gain of $500.
[edit] Depreciation
When a taxpayer purchases a tax-deductible asset for use over several years, the taxpayer can deduct a percentage of the asset’s value from his or her yearly taxable income over the life of the asset. (See IRC § 167, 168 and the IRS tables of class lives and recovery periods). The IRS publishes specific depreciation schedules for different classes of assets. The schedules tell a taxpayer what percentage of an asset’s value may be deducted each year and the number of years in which the deductions may be taken. The values of these deductions are used to determine the asset’s recomputed basis at the time the taxpayer sells the asset. (See IRC § 1245(a)(2)(A)).
For example, if a taxpayer purchased a widget with a $1,000 basis, then deducted $100 from her ordinary income each year for the widget’s depreciation, after five years the widget’s adjusted basis would be $500.
[edit] Computing depreciation recapture
When a taxpayer sells an asset for a gain after taking deductions for depreciation, depreciation recapture is used to tax the gain. Because the taxpayer received a deduction from ordinary income for the depreciation of the asset, any gain the taxpayer receives, up to the depreciation amount, must be included as ordinary income to offset the earlier deduction.
For example, the widget discussed above had an original basis of $1,000. The taxpayer took $500 worth of deprecation deductions from her ordinary income over the course of five years. At the end of those five years, the taxpayer’s adjusted basis in the asset had changed to $500. If the taxpayer sold the asset for $700, then she would realize a gain of $200. Because she received depreciation deductions, she would be required to include the $200 gain as part of her ordinary income. This is a depreciation recapture. However, if taxpayer sold the property for $1200, because her recomputed basis is $1000, $500 of the gain is taxed as ordinary income and $200 is taxed at the more favorable capital gains tax rate.
[edit] Loss
When a taxpayer takes a loss on the sale of an asset, there is no depreciation recapture. However, the taxpayer may qualify for ordinary loss treatment under IRC § 1231.
[edit] Property affected
IRC § 1245(a)(3) lists the property for which depreciation recapture rules apply. Under IRC § 1245(a)(3)(A), all personal property that can provide a depreciation offset to ordinary income is subject to depreciation recapture. Under rules contained in the current Internal Revenue Code, real property is not subject to depreciation recapture. However, under IRC § 1(h)(1)(D), real property that has experienced a gain after providing a taxpayer with a depreciation deduction is subject to a 25% tax rate--10% higher than the usual rate for a capital gain. This higher tax rate serves as a rough surrogate for depreciation recapture.
[edit] References
- Samuel A. Donaldson, Federal Income Taxation of Individuals: Cases, Problems and Materials, 2nd Edition (St. Paul: Thomson/West, 2007)
