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Depreciation Recapture: What Is It?

What is Depreciation Recapture?

Before we talk about recaptured depreciation, it’s essential to understand the basics of depreciation. Depreciation is an accounting method that allows a company to spread the cost of an asset over its useful life. Therefore, instead of taking the total cost of the asset as a one-time expense, the company can spread out the cost over several years.

When you sell an asset for more than its book value, you are liable for paying taxes on the difference. So the main benefit you can get with depreciation recapture is that it can help improve a company’s cash flow and tax reduction because depreciation is also applicable to deduct from a company’s taxable income. At the same time, your company would increase profits you would otherwise lose on taxes.

But, let’s dive into how depreciation recapture works, how it can benefit you, and the risks.

What are the Benefits of Depreciation?

Businesses should be aware of a few key benefits of tax depreciation recapture.

Recaptured depreciation can help companies keep track of their expenses. By knowing the original cost basis of an asset and the depreciation taken on it over time, companies can get a better sense of how much they are spending on each item. This information can be helpful in budgeting and forecasting future expenses.

This depreciation can also help businesses reduce their tax liability. If businesses reinvest the proceeds from the sale into new depreciable assets, they can defer paying taxes on the gain until they sell those new assets. In addition, depreciation could help to write off income and improve your cash flow. It can be a great way to minimize your tax liability and maximize your business’s profits!

Finally, tracking depreciation can also help companies to keep track of their expenses. By knowing the original cost basis of an asset and the depreciation taken on it over time, companies can get a better sense of the useful life of their assets and the significant potential investments they will need to make in the future.

What are Depreciable Assets?

A depreciable asset is an asset that will decrease in value over time due to wear and tear. The most common examples of depreciable assets are buildings, machinery, and vehicles. You can deduct the recaptured depreciation each year to reduce your taxes when you purchase a depreciable asset. At the end of the asset’s useful life, you will have taken enough deductions to equal the asset’s original cost basis.

How Does Depreciation Recapture Work?

The depreciation recapture tax rate is a tax owed on the profits and generated from the sale of depreciable assets. When you sell an asset for more than its book value, you are liable for paying taxes on the difference. The book value of an asset is its original cost minus any depreciation taken over the years.

For example, let’s say your business bought a car for $20,000, which depreciated by $15,000 over five years, and assume you took a tax write-off against the $15,000 depreciation to lower your taxes over the last five years (yay, tax savings!). The car’s book value would be $20,000 – $15,000 = $5,000.

How Is It Calculated?

If you want to sell the car for $5,000, you would not owe any sales taxes because you would only be recouping your investment minus depreciation (or book value). However, if the car is for $25,000, you would owe ordinary income taxes on the $20,000 profit. This tax is known as what is recapture tax.

To calculate the depreciation recapture tax rate, you will need to know the asset’s original cost basis and the depreciation lost on the asset over time. The original cost basis is what you paid for the asset when it was new. Depreciation is the amount the asset’s value has decreased over time due to wear and tear. To calculate the recapture tax, you will take the difference between the sale price and the original cost basis and then multiply it by the depreciation rate.

Depreciation Recapture Example

Let’s say you purchased a piece of equipment for $100,000 when it was new. Over five years, you took $20,000 in depreciation on the equipment to reduce your tax burden. If you sold the equipment for $120,000, your recapture tax would be $40,000 or $120,000 ($ 100,000 – $20,000).

It’s important to note that not all assets are subject to recapture tax. Only depreciable assets are subject to this tax.

What Are The Risks of Depreciation Recapture?

Businesses should be aware of a few key risks of depreciation recapture. First, if businesses do not reinvest the proceeds from asset sales into new depreciable assets, they may be required to pay taxes on the gain in the year you sell the asset. It can reduce your business’s bottom line!

In addition, businesses should be aware that if they do not have accurate records of their original cost basis and depreciation taken on an asset, they may overpay or underpay taxes on the asset’s sale. It can result in interest and penalties from the IRS. Therefore, it is important to keep accurate records.

Could You Avoid Depreciation Recapture Taxes?

The Internal Revenue Service (IRS) imposes a tax on the recapture of depreciation when you sell certain types of property for more than you paid. However, you may be able to avoid or minimize the tax by using one of the following strategies:

  • Use Section 1031 of the tax code, allowing you to exchange property of a like-kind and defer capital gains taxes.
  • Sell your property to a qualified conservation organization.
  • Use the installment method, allowing you to spread out capital gains taxes over the life of the loan.
  • Hold onto your property until you die. When you die, your heirs will receive a “step-up” on the basis, which means they will pay capital gains taxes only on the appreciation that occurred during their ownership.

Through these and other CRUT strategies, you may be able to avoid or minimize the tax bite.

How is depreciation recapture taxed for real estate?

The taxable gain from the sale of depreciable real property is the sum of two things. First, the ordinary income recognized from depreciation recapture tax, and second, any capital gain realized on the sale. 

For real estate, depreciation recapture is the amount of depreciation previously claimed and deducted but now included in income due to disposing of the property. For example, if you claimed $10,000 in depreciation deductions for rental property over the past five years, and sold the property for $15,000, then $5,000 would be considered depreciation recapture and taxed as ordinary income. You’d receive the remaining $10,000 as a capital gain tax.

Conclusion

Depreciation recapture is a vital tax concept for businesses to know. It can help them reduce their tax liability and keep track of their expenses. However, there are some risks associated with it as well. By understanding how it works and can help your business, you can make the most of this tax strategy!

Learn more about CRT trusts  or evaluate your potential returns with our CRUT Calculator. Schedule a time to chat with our team at no cost and with no commitment.

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