September 6, 2016

Depreciation recapture: What business owners need to know

Depreciation recapture rules apply to the disposition of an asset that was held for longer than one year, subject to depreciation or amortization, and disposed of at a gain. 

Though the 2015 extenders have allowed for some hefty deductions for taxpayers who place new fixed assets into service, including an increased Section 179 deduction and bonus depreciation, business owners can’t ignore the consequences of disposing old assets. Examples of these assets include old office equipment and fixtures such as monitors, computers, desks, furniture and cabinets, among other items.

Given that the 2016 presidential election is around the corner, business owners should pay close attention to any potential changes to the rules concerning depreciation recapture, as well as bonus depreciation and Section 179 deductions.

In order to determine how the disposal of an asset will be taxed, we need to drill down into the three major groupings of asset classification.

1. Section 1231

Under this rule, a business asset disposed of at a gain (and held for over one year) would qualify for a 15 percent capital gain tax rate. If an asset is disposed of at a loss, this would trigger an ordinary, as opposed to a capital, loss deduction. To prevent taxpayers from selecting one year to report Section 1231 gains while realizing Section 1231 losses in another year, Congress enacted Section 1231(c), a special recapture rule. Under this rule, any net gain reported has to be recaptured as ordinary income to the extent of any net Section 1231 losses deducted in the preceding five years. These losses are commonly referred to as “unrecaptured” Section 1231 losses. 

One way to avoid this recapture is to recognize a net Section 1231 gain in the current year, and postpone any net Section 1231 losses to the following year. In this case, the recapture would not apply because the “unrecaptured” Section 1231 losses do not apply retrospectively. 

2. Section 1245

This code, along with Section 1250 below, reclassifies the character of the gain on the disposed asset from that of capital into ordinary gains to the extent the depreciation or amortization deduction was allowed or allowable. Section 1245 covers primarily all tangible depreciable personal property and intangible, amortizable personal property.

3. Section 1250

This rule is similar to Section 1245, except it deals with depreciable real property. Because most assets subject to any potential recapture are fully depreciated at this point, taxpayers should mostly be concerned with the concept of the “unrecaptured” Section 1250 gain. Under this rule, all depreciation taken on the real property is subject to a 25 percent tax rate, to the extent of any gains realized on the sale of the real estate.

It is important to remember that any gain in excess of the amounts recaptured by Sections 1245 and 1250 is subject to a 15 percent tax rate as a Section 1231 gain. Additionally, if Section 1245 or 1250 property is disposed of at a loss, the whole amount is treated as a Section 1231 loss, and the recapture provisions do not apply. 

While the rules differ in certain circumstances – including installment sales and charitable donations – this is the general crux of the depreciation recapture rules.

With proper planning, depreciation recapture can be reduced, shifted, postponed, or even eliminated by taking advantage of low tax brackets, net operating loss carryovers and completing like-kind exchanges.


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