The vast majority of businesses have depreciable assets: company property, buildings, equipment, vehicles, etc. Because they are used for business purposes, claiming depreciation of these assets helps to reduce the taxable income of the business. As is the case any time you wade into the murky waters of tax, the IRS is always on the lookout to ensure the U.S. Treasury gets its fair portion. Depreciation recapture is intended to keep companies from manipulating tax law to obtain an ordinary expense on depreciation, and then recognize long-term capital gains (a more favorable tax rate) on the sale of the asset.
One thing leads to another, and suddenly you find yourself facing depreciation recapture because you sold a business asset last year. We’re going to break down assets, depreciation recapture, and how to understand the impact that depreciation recapture may have on your overall tax picture. As is the case with any complex tax situation, it’s always a good idea to consult with your CPA before making any big decisions.
What is a depreciable business asset?
For tax purposes, depreciable assets differ from expenses in that they are generally big-ticket items that cost more than $2,500 at the time of purchase and have a lifespan of over a year in service. Say your business purchases a $300 printer and a $3,000 copier this year. The printer is an expense and would most likely be a tax deduction that year. The copier, on the other hand, is an asset, and therefore subject to depreciation rules.
For tax purposes, depreciation is calculated based upon a class life as determined by the Internal Revenue Code. Certain asset classes have accelerated depreciation options. In laymen’s terms, depreciation generally involves breaking down the cost of an asset and deducting some portion of it each year for a set period of time. That period of time varies based on the asset—the copier’s depreciation schedule would likely be shorter than a more costly asset, like your office building.
How are depreciation schedules determined?
Tax law sets depreciation schedules based upon the class of the asset. These schedules tell a taxpayer what percentage of an asset’s value may be deducted each year and the number of years for which the deductions may be taken.
- The most common tax method to compute depreciation is the modified accelerated cost recovery system, MACRS. MACRS gives you the option to apply a larger tax deduction in the early years of an asset’s useful life and less as time goes by.
- Bonus depreciation may also be an option when creating a depreciation schedule. It allows taxpayers to deduct 100% of the cost of an asset the year it’s purchased, as long as it’s placed in service that same year and meets many other requirements.
- Taxpayers may also write off the cost of certain property as an expense when the property is placed in service, per the terms of the Section 179 Election.
We advise consulting with a licensed tax professional in order to ensure you’re using the proper depreciation schedule. While an accelerated or bonus schedule may seem attractive, it’s not always the best choice over time (particularly if the asset is financed).
When is depreciation recaptured?
Depreciation recapture comes calling when you dispose of the depreciable asset. Over time, assets lose their value (i.e. depreciate). Some assets, such as vehicles, are often traded in for a newer model. Others, like real estate, might be sold. Depreciation recapture is a tax provision that allows the treasury to collect taxes on the profit made from the sale of that asset—regardless of whether you traded the asset for a new piece of equipment or sold it outright. Any gain on the asset will trigger depreciation recapture; different asset classes have different tax rates on recapture. You need to be concerned about depreciation recapture any time your dispose of an asset.
We strongly encourage working closely with your CPA to understand the tax implications of any sale of depreciated assets. If you have any questions about depreciation recapture and how it might affect your tax planning strategy, please contact us to schedule a consultation.