When Is Depreciation Fully Recaptured?
Depreciation recapture is a creation of the Internal Revenue Service to compensate for the fact that often the real world and ideal world do not converge in tax situations. Ideally, the amount of an asset that a business expenses during a year would match the actual decline in value. This rarely happens, so the IRS requires depreciation recapture on any amounts in excess of the book value of an asset upon the disposition, or sale.
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Section 1231 Assets
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Section 1231 assets are capital assets that contribute to income production and are held long-term. They include two categories: Section 1245 property and Section 1250 property. Section 1250 property is real property, which includes land and anything attached to the land such as buildings and swimming pools. Section 1245 property is anything that is not real property. It is personal property that the company uses for purposes of producing income. Whether the asset is Section 1245 or Section 1250 property is pertinent to how to recapture depreciation.
Depreciation and Depreciation Recapture
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The adjusted basis of an asset is its purchase price, plus upward adjustments for capital additions such as repairs, maintenance and improvements, and downward adjustments for depreciation. An entity may depreciate the entire adjusted basis of an asset over its useful life if it believes there is no salvage value. When the asset is no longer of use to the company, it can sell it or dispose of it. The amount that the company receives for the sale may be more than the adjusted basis. If this happens, the IRS requires recapturing the extra depreciation and taxing it at ordinary income rates.
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Fully-Recaptured Depreciation for Section 1245 Property
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If personal property used in a business, or Section 1245 property, either maintains its value or appreciates in value over time, but the company writes off a depreciation expense each period, then the amount must be fully recaptured. Put another way, if the amount realized from the sale is greater than the adjusted basis of the asset and gain is greater than depreciation, then the IRS requires fully recapturing any depreciation taken. This amount is taxable as ordinary income. For example, Joe purchases a tiller for use in his landscaping business for $1,200 and it maintains it value despite the use. Joe depreciates the tiller $100 per year for the two years he uses it. At the end of two years, he decides to sell it and purchase a new model. Jane pays Joe $1,200 for the tiller. The IRS requires that recapturing of the $200 of depreciation by Joe.
Fully-Recapture Depreciation for Section 1250 Property
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For real property, or Section 1250 property, that maintains its value or appreciates, then the depreciation amount must be fully recaptured by the business. This amount is subject to taxation as ordinary income. For example, if Bill purchases an apartment building for $200,000 and then sells it at a later date for $750,000 after taking $100,000 in depreciation, the $100,000 must be fully recaptured. The IRS taxes the $100,000 as ordinary income. Any gain in excess of the adjusted basis is taxed as capital gains.
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