Recapture of Depreciation - Explained
What is Recapture of Depreciation?
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Table of ContentsWhat is Depreciation Recapture?How Does Recapture of Depreciation Work?Academic Research on Recapture of Depreciation
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.
How Does Recapture of Depreciation Work?
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 assets 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-($3000x4) = $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.