At some point you’ll no longer have a need for a business asset, whether it’s a vehicle, a machine, or an office building. Things wear out, become obsolete, or no longer fit. You have probably been taking annual depreciation deductions for the asset, and may even have written it off entirely. Uh, oh—the disposition might trigger tax payback, or recapture. Let’s look at the rules here for all (noncorporate) businesses. IRC-1231 and IRC-1245 are the two guiding tax code provisions as discussed in this post.
Gain Triggers Depreciation Recapture Tax
Any gain you make over your tax basis in the asset is taxed. Your tax basis is figured by subtracting the depreciation deductions you’ve taken on it from what you have invested in it.
Fannie sells a 20-foot custom teak conference table that doesn’t fit into her new law office. She paid $10,000 for it, and over several years took $8,000 in depreciation deductions. Her tax basis is $2,000. Fannie sells it to Vonny for $2,500.
Tax result: Fannie owes income tax on $500 ($2,500 – $2,000), the gain the tax law says she had after the recapture of previously claimed tax deductions.
Recapture Taxed at Ordinary Income Tax Rates
If a gain on a sale is all from the recapture of depreciation deductions, it is taxed at ordinary income tax rates and not at lower capital gains tax rates.
Returning to Fannie’s situation, her $500 gain represents a recapture of depreciation deductions taken in past years. If Fannie’s individual income tax rate is 25%, her income tax on the gain from the sale of the desk is $125. Depending on her state of residence, Fannie may owe state income taxes as well.
Gain Other Than Recapture May Be Taxed at a Lower Rate
If a business asset was sold for more than the total depreciation deductions taken in past years, the tax is figured at the Section 1231 tax rate. Generally, this means a tax rate lower than the ordinary income tax rate for an individual. (See IRS Publication 544, Sales and Other Dispositions of Assets, for details on how this tax calculation is made).
Let’s say Fannie, from the examples above, sells the table to Regina for $12,500. Remember Fannie’s original outlay was $10,000. Her tax basis was $2,000, as she had taken $8,000 in deductions over several years.
Tax result: Fannie is treated as having a $10,500 taxable gain on the sale. Out of Fannie’s gain, $8,000 is attributable to depreciation deduction recapture and is taxed at her ordinary income tax rate of 25%. But the remaining $2,500 is taxed at the special Section 1231 tax rate, which in her case is 15%. Her capital gain tax is $375 ($2,500 x 15%).
Like-kind exchanges avoid depreciation recapture. You simply trade in a business asset for another one with no tax consequences.
Rudy, a drywall contractor, trades in his three-year-old small Ford pickup for a new full-sized Chevy truck. Rudy also pays the dealer $10,000. No matter how much depreciation Rudy took on his Ford in the past, he won’t have any taxable gain (or loss). This a like-kind exchange of business assets.
Destroyed or Stolen Assets
If a business asset becomes damaged, destroyed, or stolen, the IRC terms this an involuntary conversion. If the loss was fully reimbursed by insurance, there is no tax consequence, if the insurance proceeds are used to replace the asset. The involuntary conversion avoids depreciation recapture.
Rudy, in the example above, wrecks the Ford pickup on the way to the Chevy dealer. Allsnake Insurance declares the truck a total loss and pays him $9,000. This is $2,200 more than Rudy’s tax basis in the Ford, which would normally mean he would owe income tax on a $2,200 gain from recapture of depreciation. But, if Rudy buys the Chevy for at least $9,000, there’s no taxable gain.
Sale of Real Estate
If your business sells or otherwise disposes of real estate that was depreciated in prior years, special tax recapture rules apply. Briefly stated, this means prior depreciation deductions are now taxed, and at ordinary income tax rates.The income taxation of real estate is beyond the scope of this post. See a tax professional or IRS Publication 544, Sales and Other Disposition of Assets, for details on real estate tax rules.