4.4 Depreciation recapture

Depreciation recapture 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 personal property (Section 1245) and real property (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 Internal Revenue Code 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, depreciated by$60,000, sold for $90,000 results in$50,000 recapture as ordinary income
• Office building (Section 1250 property) acquired for $1,000,000, depreciated by$200,000 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 adjusted basis
• 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 (triggers recapture of entire$5,000 as ordinary income)
• Factory destroyed by fire, insurance payout of $500,000 exceeds adjusted basis of$300,000 (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 straight-line depreciation
• 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, depreciated by$40,000, sold for $120,000 results in$40,000 recapture as ordinary income and $20,000 as capital gain
• Real estate with $500,000 total depreciation sold at$1,000,000 gain may have $200,000 recaptured as ordinary income,$300,000 as unrecaptured Section 1250 gain (25% rate), and $500,000 as capital gain