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What is Depreciation Recapture?
Depreciation Recapture is a procedure by the Internal Revenue Service (IRS) to collect taxes on property that has been depreciated and is later sold for a gain. More specifically, it requires the businesses to report the gain realized from the sale of a depreciable capital property as an ordinary income and not as a capital gain.
A Little More on What is Recapture of Depreciation
When a depreciating asset (such as equipment) is sold for more than its book value (purchase price or original basis minus depreciation) the amount of depreciation is recaptured. The amount is considered to be ordinary income. In other words, if the sale price of a depreciable asset is more than its adjusted cost basis, the difference between these two figures has to be reported as taxable income.
The business assets which lose value over time are known as depreciable assets. The value that is lost on such assets over the years is calculated as depreciation expense. Companies calculate the depreciation expense each year for the purpose of computing tax liability. This allows a company to divide the cost of an asset over several years. Depreciation expense decreases the adjusted cost of the asset; as a result, the tax gets reduced.
The IRS issues notifications with specific depreciation schedules for different classes of assets. The taxpayer needs to follow that schedule while deducting the asset’s value. The schedule provides the details saying what percentage to be deducted each year and for how long the deductions may continue.
Depreciation of an asset is used for deducting ordinary income, so any gain from disposal or sale of such assets must be recorded as an ordinary income.
The first step for determining a depreciation recapture is to determine the cost basis of the asset. The original cost basis of an asset is the value paid by the company to acquire the asset. It is the purchase price of the asset. This cost basis can be adjusted or recomputed for different reasons including the tax deduction for depreciation.
An adjusted cost basis under IRC 1016 is the original basis minus any decreases for depreciation deductions allowed or allowable for such asset.
If a business purchases an asset with $20,000 and allowable deduction for the next 4 years are $3,000 per year, then its adjusted cost basis after 4 years would be $20,000-($3000×4) = $8,000.
If the company sells the asset at $10,000 after four years of its purchase the taxable gain would be $10,000-$8,000=$2,000.
If we compare the selling value with its original cost basis then the company has incurred a loss of $20,000-$10,000=$10,000 but the gains and losses must be calculated according to its adjusted value and not based on the original cost basis.
The realized gain from the asset is $2,000 and it must be recorded as an ordinary income in the tax file. It is considered as depreciation recapture. If the asset is sold at a lower price than its depreciated value, then there is no depreciation to recapture. In this case, the company may qualify for ordinary loss treatment.
The rule applies differently to the gain from the sale of a rental property. The rate of capital gain is partly applied to the gain from a sale of a residential rental property. Part of the gain is taxed as capital gain and the part that is related to depreciation is taxed as ordinary income.
For example, a homeowner buys a home with $400,000 and it has an annual depreciation rate of $30,000. After 5 years the owner sells the property at $500,000. The adjusted cost basis of the property is $400,000 – ($30,000 x 5) = $250,000. The realized gain from the sale is $500,000 – $250,000 = 250,000. The capital gain on the property will be calculated as $250,000 – ($30,000 x 5) = $100,000 and the depreciation recapture gain is ($30,000 x 5) = $150,000.
Now, if the tax rate on the capital gain is 15% and the tax rate on the ordinary income for the owner is 30%. The total amount of payable tax for the sale would be, (0.15 x $100,000) + (0.30 x $150,000) = $60,000. The depreciation recapture is $45,000.
References for Recapture of Depreciation
Recapture of Depreciation
Recapture of Depreciation and Section 1245 of the Internal Revenue Code, Schapiro, D. (1963). The Yale Law Journal, 72(8), 1483-1514. This paper discusses The Revenue Act of 1962 that brought into the tax base many items which previously had been considered unrealized income and thus not subject to tax. It also expanded the scope of the ordinary income tax at the expense of the capital gains tax. The paper also discusses the recapture of depreciation under the newly enacted code section 1245.
Recapture of Depreciation, Fuller, H. F. (1964). Tul. L. Rev., 39, 15. This article investigates the relationship between depreciation deductions and the tax effects to the property owner arising from the subsequent disposition of the depreciated property. This is mostly known as the conversion of ordinary income depreciation deductions into long-term capital gain. The article also suggests that other dispositions apart from sales have offered significant tax advantages to the holders of depreciated property.
Minimum Tax, Recapture and Choice of Depreciation Methods, Sirmans, C. F. (1980). Real Estate Economics, 8(3), 255-267. This study investigates the challenge of the trade-off between the potential minimum tax effects of accelerated depreciation, the recapture of excess depreciation, and the choice of depreciation methods to maximize investor wealth. It utilizes a model that is simulated for several ranges of inputs to which the decision of depreciation selection is highly sensitive.
Accelerated Depreciation: Tax Expenditure or Proper Allowance for Measuring Net Income?, Kahn, D. A. (1979). Michigan Law Review, 78(1), 1-58. This article presents two complaints against tax expenditures. It argues that the tax expenditures are hidden within the tax system and thus are not carefully scrutinized as the direct expenditures. It also states that they change the proportionate burden imposed by the progressive tax system and therefore violate the principles of horizontal and vertical equity.
The” Recapture” of Excess Tax Depreciation on the Sale of Real Estate, Brannon, G. M., & Sunley Jr, E. M. (1976). National Tax Journal, 413-421. This paper explains how a recapture is essential for the sale of very old buildings and then proposes a formula for performing it. In case of excessive tax depreciation, the taxpayer forfeits some of the gains and sells the building early even if the gain is taxed at capital gains rates. The paper suggests that excessive depreciation on buildings should be cut back for both developer-holders and developer-sellers.
Depreciation Recapture in International Liquidations, Kramer, J. L. (1975). Int’l Tax J., 2, 335. This article discusses the decisions to apply depreciation recapture upon the liquidation of a foreign corporation. It reviews the effects of depreciation recapture and other identical provisions on the liquidation of foreign corporations and provides alternative strategies which can prevent the unfavorable impacts of depreciation recapture.
Nonrecourse Financing of Real Property: Depreciation Allocation and Full Recapture to Minimize Deferral and Eliminate Conversion, Ji, S. I. (1995). Colum. JL & Soc. Probs., 29, 217. This paper explains nonrecourse debt as a financing method that allows the borrower to avoid personal liability. In case of a default, the primary recourse of a lender is to the property securing the debt. The participants of a transaction utilize nonrecourse debt to allocate economic risks. The tax impacts on nonrecourse financing are taken from two crucial principles from the case study of Crane v. Commissioner.
The windfall recapture tax: Issues of theory and design, Zodrow, G. R. (1988). Public Finance Quarterly, 16(4), 387-424. This study reviews the tax reform package that was issued by the Reagan administration to include a proposal to evaluate a windfall recapture tax on the owners of existing depreciable assets although this proposal was controversial. It also analyzes the questions regarding the efficiency and equity properties of the proposal and provides the theoretical and numerical analysis of other potential design approaches.
Real Estate Depreciation and Low-Income Housing, Kelley Jr, W. A., & Aronsohn, A. J. (1969). Tax Law., 23, 555. This paper explains how since 1961 the administration had been proposing various amendments into the Internal Revenue Code which were aimed at limiting the real estate tax shelter. The Revenue Act of 1962 was finally passed, and it added a section 1245 to the Internal Revenue Code allowing for the recapture of all depreciation in the case of tangible personal property without providing for recapture in the case of real estate.
Real Property Depreciation Recapture: An Ineffectual Reform of the Tax Laws, Franklin, C. S. (1965). Vand. L. Rev., 19, 1336. This article describes the Internal Revenue Code and illustrates how tax laws provide particular unique benefits to real estate investors. It explores the efforts made by the US Treasury in reforming the law. The article also surveys the relevant economic principles to suggest a few important guidelines to be used in the future efforts of reform.
Disallowance of Depreciation in the Year of Sale at a Gain, McNerney, M. A. (1964). Tax L. Rev., 20, 615. This paper discusses case study whereby ranting a taxpayers petition for certiorari in the Fribourg Navigation case; the Supreme Court virtually assured that the October 165 term was going to present an answer to the question regarding whether a deduction for depreciation was allowable for the year in which an asset is sold at a profit.