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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. For business real estate, there is a special, more generous rule for home offices.
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:
- the total of depreciation and expensing deductions allowable on the asset, and
- the total gain realized
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.
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Example
On April 30, 2007, Albert Edwards sold a car for $5,000. The original cost of the car in 2001 was $13,000. The car had been driven 75,000 miles, 60,000 of which were attributable to business usage. Edwards used the standard mileage rate to claim car deductions, which includes a depreciation component. Assume the depreciation treated as allowable for those years was $7,200. Edwards sold no other business property during the year. Edwards has a business gain of $800, computed as follows:
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Business |
Personal |
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Total |
(80%) |
(20%) |
| Cost of car |
$13,000 |
$10,400 |
$2,600 |
| Less: depreciation |
7,200 |
7,200 |
0 |
| Adjusted basis of car |
5,800 |
3,200 |
2,600 |
| Less: sale proceeds |
5,000 |
4,000 |
1,000 |
| Gain (loss) |
($800) |
$800 |
($1,600) |
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In the example above, the full amount of the business gain of $800 is treated as ordinary income because it is less than the amount of depreciation that was taken on the car. Remember, the personal loss is not deductible!
Recapture of real estate depreciation. Gain on the sale of real estate 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.
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, and 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.
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Warning
Don't let the tail wag the dog. Strategies aimed at the timing or minimization of depreciation recaptures may be worthwhile, but don't fall in the trap of over-focusing on tax issues. First, consider the business consequences when deciding whether and when you should sell an asset. Tax considerations should run a distant second when making these kinds of decisions.
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