Understanding Depreciation Recapture and How It’s Taxed

Asset management requires meticulous record-keeping and financial accounting as assets gain or lose value over time. When the time comes to move off high-value assets it’s imperative to consider the tax implications of these transactions.

Implementing an effective tax strategy to get the most out of your money allows you to save cash while building on your investments. This also means paying close mind to the evolving value of an asset and how capital gains taxes or depreciation recapture will be applied at the time of sale.

Depreciation recapture explained

Almost all assets depreciate over time, lowering the value from the time it was purchased and costing the buyer equal value. The way depreciation is claimed vs. how it is realized during the sale of an asset matters to the IRS. Taxpayers can use depreciation to offset their taxable income (for both individuals and businesses).

Recapture occurs when gain is realized on a depreciable asset that exceeds the lowered tax basis. This recapture is considered income which must be reported on IRS Form 4797.

For example, if you purchase an asset for $500,000 but claim depreciation on the asset over ten years at a rate of $20,000 per year, you would be left with a tax basis of $300,000. The $200,000 is a deduction that can offset income, but if you were to sell the asset for $400,000 at that point, there would be a $100,000 difference that would result in depreciation recapture.

Another wrinkle in this comes from a Trump-era tax reform that permitted businesses to write off the depreciation of an asset upfront as opposed to expensing depreciation of the asset over time. This law allows 100% of the depreciation to be deducted and claimed on your tax return upfront in the year of purchase. However, again, for example, if you were to sell asset after one  year, the entire amount would be subject to depreciation recapture. 

Taxing depreciation recapture

Depreciation recapture, as noted above, will be taxed as income. This has a maximum rate of 25%. Continuing the above example, we will consider an asset that started at a $500,000 value but was depreciated by $20,000 a year for 10 years, resulting in a new tax basis of $300,000.

When the asset is sold for $400,000, the $100,000 difference will be recognized as basic income. If you were to face the maximum tax rate on this income, you would owe a $25,000 income tax. If depreciation recapture had not applied, the $100,000 would very likely have been taxed at a much lower rate. 

However, depreciation capture can face additional taxes such as the Net Investment Income Tax (NIIT). Individuals who meet income thresholds for the NIIT will face a 3.8% tax on certain net investment income. The thresholds are:

  • $200,000 for single taxpayers and head of household
  • $250,000 for those who are married and file jointly or qualifying widows with dependent children
  • $125,000 for those who are married and file separately

If you meet one of those thresholds, then the additional 3.8% tax on the above example would take the tax bill from $25,000 to $28,800 (25% income tax + a 3.8% NIIT).

While depreciation recapture is taxed purely based on the difference between the tax basis after claimed depreciation, NIIT is taxed on the entire gain of a sale. If the sale exceeds the original value of the asset, a depreciation recapture will only tax the depreciation claimed that you have recaptured in the sale (in this case, $200,000 in claimed depreciation) while the NIIT would include both the claimed depreciation and the additional value received above the original tax basis at the time you purchased the asset.

Implement an effective tax strategy

As you can see, this tax burden can be significant on depreciable assets. However, a variety of effective tools and tax strategies allow you to avoid these charges – including the use of a 1031 Exchange.

At the Law Offices of Tyler Q. Dahl, we work closely with clients to determine the best tax strategy for themselves or their businesses. Contact our team and navigate these complicated tax matters with guidance from our experienced legal team.

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