is a crucial concept in tax planning for businesses. It prevents double-dipping on tax benefits by requiring gains from selling depreciable assets to be reported as ordinary income, offsetting previous depreciation deductions.
The rules differ for (Section 1245) and (Section 1250). Understanding these distinctions is key for effective tax strategies when selling business assets, as recapture can significantly impact after-tax proceeds.
Depreciation Recapture
Concept and Purpose
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Depreciation recapture requires taxpayers to report gains from selling depreciable property as ordinary income, attributable to previous depreciation deductions
Prevents taxpayers from benefiting from both depreciation deductions and capital gains treatment on the same asset
Section 1245 of the governs recapture for most depreciable personal property, treating recaptured amount as ordinary income
Section 1250 applies to real property, potentially resulting in partial ordinary income and partial capital gain taxation
Tax rate on recaptured depreciation typically exceeds capital gains rate, potentially increasing tax liability
Significantly impacts after-tax proceeds from business asset sales (crucial for tax planning strategies)
Regulatory Framework
Personal property recapture governed by Section 1245 (treats entire recapture as ordinary income)
Real property recapture governed by Section 1250 (may result in mixed ordinary income and capital gain treatment)
Unrecaptured Section 1250 gain on real property subject to 25% maximum tax rate for individual taxpayers
Corporations taxed at corporate rate for entire recapture amount (no preferential capital gains rates)
Examples and Illustrations
Manufacturing equipment (Section 1245 property) purchased for 100,000,depreciatedby60,000, sold for 90,000resultsin50,000 recapture as ordinary income
Office building (Section 1250 property) acquired for 1,000,000,depreciatedby200,000 using accelerated method, sold for $1,300,000 may have partial ordinary income recapture and partial capital gain treatment
Triggers for Recapture
Asset Dispositions
Sale or exchange of depreciable property for price exceeding
Involuntary conversions (property destruction with insurance proceeds exceeding adjusted basis)
Distribution of depreciable property by corporation to shareholders (fair market value exceeds adjusted basis)
Abandonment or retirement of depreciable property (consideration received)
Special Transactions
Like-kind exchanges under Section 1031 may defer recapture, but triggered if boot received
Gifts of depreciated property to charitable organizations (property subject to debt exceeding basis)
Examples of Triggering Events
Company sells fully depreciated delivery truck for 5,000(triggersrecaptureofentire5,000 as ordinary income)
Factory destroyed by fire, insurance payout of 500,000exceedsadjustedbasisof300,000 (triggers recapture on $200,000 difference)
Calculating Recapture Amount
General Principles
Recapture amount limited to lesser of total depreciation taken or gain realized on sale
For Section 1245 property, calculate difference between asset's recomputed basis and adjusted basis
Recomputed basis equals original cost plus improvements minus depreciation allowed or allowable
For Section 1250 property, determine excess of accelerated depreciation over
Gain exceeding recapture amount generally treated as Section 1231 gain (may qualify for capital gain treatment)
Calculation Methods
Section 1245 calculation: Gain = Sales price - Adjusted basis, Recapture = Lesser of (Total depreciation, Gain)
Section 1250 calculation: Ordinary income = Excess of accelerated depreciation over straight-line depreciation
Unrecaptured Section 1250 gain = Lesser of (Total gain, Remaining depreciation not recaptured as ordinary income)
Special Considerations
Special rules apply for assets held for different periods or depreciated under various methods
Partial dispositions may require allocating basis and recapture amounts proportionally
Impact of Recapture on Gain/Loss
Character of Gain
Converts potential capital gain into ordinary income, potentially increasing overall tax liability
Gain character determined in specific order: depreciation recapture as ordinary income, unrecaptured Section 1250 gain, remaining gain as capital gain
Particularly significant for substantially appreciated assets (larger portion subject to recapture)
Tax Planning Implications
Consider potential for depreciation recapture when structuring transactions involving depreciable assets
Strategic timing of asset sales can manage recapture impact on overall tax liability in a given year
Evaluate trade-off between accelerated depreciation methods and future recapture tax consequences
Examples of Recapture Impact
Asset purchased for 100,000,depreciatedby40,000, sold for 120,000resultsin40,000 recapture as ordinary income and $20,000 as capital gain
Real estate with 500,000totaldepreciationsoldat1,000,000 gain may have 200,000recapturedasordinaryincome,300,000 as unrecaptured Section 1250 gain (25% rate), and $500,000 as capital gain