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If you realize a capital gain on the sale or other disposition of property used in your trade or business, you probably won't get the benefit of the special capital gains tax rate on the entire amount of your gain.
Why not? Because Congress wants to first take back, or "recapture," some of the benefits of the depreciation deductions you've been claiming for all the years you owned the property.
The tax rules for recapture differ, depending on whether the property is real estate or personal property.
Recapture rules for personal property. If you have a capital gain on any depreciable personal property other than real estate, you must report all or part of the gain as ordinary income to reflect the amount of depreciation, and any first-year expensing deductions that were claimed on the asset. The amount that must be reported as ordinary income ("recaptured") is not eligible for the special long-term capital gains rates described above, and is equal to the lesser of:
If the total gain realized is more than the amount that must be recaptured, the excess will be taxed at the long-term capital gain rate, provided that the asset has been held for more than one year. If the total of the depreciation deductions is greater than the gain realized, the entire amount of the gain is reported as ordinary income.
Recapture of real estate depreciation. Gain on the sale of depreciable real estate property is treated as ordinary income to the extent of additional depreciation allowed or allowable on the property. For property held over a year, the additional depreciation is the actual depreciation adjustments that are more than the depreciation using the straight-line method.
However, there are many situations where you are not required to recapture any additional depreciation when you dispose of real property. Additional recapture of depreciation is not necessary if:
The property was residential rental property or nonresidential real property placed in service after 1986; you held it longer than 1 year; and, if the property was qualified property, you made a timely election not to claim any special depreciation allowance.
Depreciation recapture for real estate is computed on Form 4797, Sales of Business Property.
Planning for depreciation recaptures. If you choose to depreciate a property quickly, the property's adjusted basis will be reduced more quickly than if you had depreciated the property more slowly. Thus, if you sell in the first few years, you will have more taxable gain on the sale of the asset.
Moreover, as a general rule, the faster you depreciate property, the more likely it is that you will have a recapture liability when you sell the property, and the more likely that this liability would be larger than if you have chosen slower depreciation.
All things being equal, it's probably best to be hit with a recapture in a year in which your business has an operating loss (which can be used to offset the recapture amount), rather than in a profit year, when the recapture liability will increase your taxable income, and possibly even move you into a higher tax bracket.