The beauty of owning depreciable assets is that depreciation can be applied each year to reduce your taxable income and account for the wear and tear on asset values. For companies in industries like manufacturing and construction, this allows for large deductions on high capital expenditures like buildings, equipment, and machinery. The benefits don’t last forever, though. When you sell a depreciable asset, the IRS uses depreciation recapture to collect taxes on gains you’ve realized and income you’ve previously offset. Luckily, depending on the assets being sold, there are steps business owners can take when purchasing, depreciating, and selling their assets that can minimize the tax due at final sale.
How does depreciation recapture affect taxes?
The original cost basis of an asset is the price you paid to acquire that asset. The depreciation you claim on that fixed asset reduces the asset’s original cost basis to an adjusted cost basis. When you want to sell that asset, the difference between the adjusted cost basis and the sales price is the amount subject to depreciation recapture. Since the depreciation deduction was applied to reduce your ordinary income during your ownership of the asset, when you sell the asset, a portion of the gain will be subject to ordinary income tax rates, not the more favorable capital gains tax rate. The amount subject to ordinary income is limited to the amount you claimed as depreciation. Any increase in value from the time you purchased it qualifies for the preferential capital gains rate. The only exception is when you buy a real estate asset and take straight-line depreciation. If you sell that asset for a gain, you will just owe capital gains tax on the net gain. The seller of the asset pays any depreciation recapture tax and it’s due when filing taxes for the year of the sale.
Let’s look at a depreciation recapture example:
ABC Company buys a piece of equipment for $10,000. This is the original cost basis of the asset. In that same year, they take Section 179 accelerated depreciation and receive a $10,000 deduction on taxable income. This reduces the basis in that asset to an adjusted cost basis of $0 since the entire $10,000 was deducted as an expense. In the following year, ABC company sells the same piece of equipment for $5,000. Since the asset has an adjusted cost basis of $0, the net taxable gain of the sale is $5,000. Since there is a gain on the sale of the asset and accelerated depreciation was used previously to reduce ordinary income, the $5,000 net gain would be recaptured at ordinary tax rates under Section 1245.
What kind of assets are subject to depreciation recapture?
There are two categories of assets for depreciation recapture: Section 1245 and Section 1250. Section 1245 entails depreciation recapture on personal property like machines, vehicles, furniture, etc. Section 1250 includes depreciation recapture on real property like commercial buildings, warehouses, rental properties, etc. The tax rate applied to the amount recaptured is different for each category of asset. For Section 1245, the recapture rate is at ordinary tax rates while Section 1250 property is generally taxed at a maximum rate of 25%.
It’s important to note that not all fixed asset sales are subject to depreciation recapture. If a fixed asset is sold for a loss, for example, there is no depreciation recapture since there is no gain or income to be taxed. There’s also no depreciation recapture if a section 1250 asset was depreciated using straight-line (not accelerated) depreciation.
How can business owners minimize depreciation recapture?
First, business owners can smartly deduct depreciation when acquiring the asset. We typically recommend that clients accelerate depreciation to take the deductions immediately versus taking the deduction over an extended time period. It usually is better to take the higher deduction now and re-invest that money for long-term growth. One exception is when you have a low income year and are expecting large income years in the near future.
Second, when it comes time to sell the asset, we recommend owners try to allocate as much of the sale price to assets that are not subject to Section 1245 recapture. These are taxed at ordinary tax rates, while Section 1250 is capped at a 25% tax rate. For example, allocate as much of the purchase price to real estate instead of vehicles to take advantage of the 25% tax rate vs. a potential 37% tax rate. Or even better, assign the sales price to self-created goodwill since it will be taxed at capital gain rates. During the sale process while the sale price is being negotiated, a form 8594 will be completed that discloses the asset allocation. Both sides should agree to the allocation before this form is complete.
Third, in a year when a client plans on selling or trading assets where they expect depreciation recapture due, we recommend purchasing additional assets to accelerate new depreciation deductions and offset any income generated by the sale of the original assets.
Depreciation recapture is important to consider when buying and selling fixed assets; both occurrences can greatly affect your taxable income. If you’re navigating asset purchases or sales and want to better understand the tax impact, schedule a consultation with us today.
