The Tax Code giveth and the Tax Code taketh away.
The depreciation and expensing provisions in the Tax Code allow taxpayers to recover the cost of property through an annual allowance. As a result, many businesses have taken advantage of the opportunity to write off expenses of equipment and other tangible property by making purchases toward the end of the year, driven as much by the tax advantage it gives them as by the actual need for new equipment.
But many of these business owners forget that when they sell an asset, the IRS can take their depreciation allowance back, often at the highest possible tax rate. Taxpayers use depreciation to write down the cost of assets, both tangible assets like capital equipment and real property, and intangible assets such as patent costs and goodwill. But if those assets are sold at a profit, the IRS can recapture the full amount that was depreciated.
“Contrary to what many taxpayers assume, the agency doesn’t apply the preferential capital gains tax rate to depreciated assets sold at a profit,” said Peter Blumkin, senior manager in the tax department at the New York-based accounting firm Marks Paneth & Shron. “Instead, in many cases the IRS recaptures depreciation at the ordinary income tax rate, which can reach as much as 39.6 percent in the highest bracket. The lower capital gains rates kick in only after the IRS gets all of its depreciation back.”
“That can mean a much higher than expected tax bill on the sale of the asset,” he observed. “Taxpayers—and their advisors—need to realize that there’s a downside to depreciation. It can be more costly than expected in the event of a sale.”
Tax professionals need to make their clients aware of the potential pitfalls involved in selling assets that might be subject to depreciation recapture.
This is especially true given the exceedingly generous depreciation allowances of the past decade, Blumkin indicated. In recent years, business owners, partners and other high net-worth individuals have been aggressive in claiming deprecation, often using preferential first-year bonus depreciation rates that have ranged from 30 percent to 50 percent, and for a time hit 100 percent.
“But when these taxpayers sell the asset, they often find that depreciation comes back to bite them,” Blumkin said. “Some or all of the previously derived tax benefits could be negated when the affected assets are disposed of.”
“Depreciation recapture applies to the disposition of an asset that is held more than a year, is subject to depreciation or amortization, and is disposed of at a gain,” Blumkin noted. “A common misconception exists that a business asset disposed of at a gain automatically qualifies for a 15 percent preferential capital gain tax rate, or 20 percent for taxpayers in a 39.6 percent tax bracket. This is where the recapture rules come into play.”
The good news is that with proper planning, depreciation recapture can be reduced, shifted, postponed or even eliminated, according to Blumkin.
Reducing recapture effects can be accomplished by recognizing ordinary income when the taxpayer is in a low tax bracket or when he or she has a net operating loss carryover. If a taxpayer makes a bona fide gift of depreciable property, the recapture potential will be shifted to the donee. And one can postpone the recapture provisions by completing a like-kind exchange, in which case the recapture is not triggered upon the exchange, but is carried over to the replacement property.
“With the Bush-era tax cuts extended through the end of 2013, it is more important than ever to recognize that while taking bonus depreciation or Section 179 deductions on leasehold improvements will almost always be beneficial, using the same approach on personal property assets will only defer the recapture,” said Blumkin.
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