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Depreciation Recapture

Our firm often deals with the proper treatment of certain dispositions of property on which businesses claimed depreciation deductions. Under the depreciation recapture rules, when a taxpayer disposes of property for which depreciation deductions were claimed, some or all of the gain may be taxed at higher rates than the favorable capital gain rates. These rules apply to depreciation deductions claimed under the regular depreciation rules, under the accelerated cost recovery system (ACRS) and under the modified accelerated cost recovery system (MACRS). The rules apply to sales, exchanges, involuntary conversions, sale-leaseback transactions, and transfers on foreclosures of security interests.

For sales, exchanges, and involuntary conversions, the amount of depreciation recapture generally equals the applicable percentage of the lesser of: (1) certain additional depreciation; or (2) the excess of the amount realized over the property’s adjusted basis. For property held for one year or less, additional depreciation means all depreciation deductions claimed on the property that are reflected in its adjusted basis. For example, if you buy a building for $450,000, and claim $6,000 of depreciation, and sell it within one year for $500,000, no matter what method of depreciation is used, the additional depreciation is $6,000 (assuming the applicable percentage is 100%). For property held more than one year, additional depreciation means the amount of the depreciation deductions claimed on the property that are reflected in its adjusted basis that exceeds the amount of depreciation deductions that would have been claimed had the straight-line method of depreciation been used. If, for example, you owned the building for more than one year and the depreciation taken was $22,000 (using an accelerated method), and under the straight-line method the depreciation would be $18,000, the additional depreciation on the property is $4,000 ($22,000 less $18,000). If the straight-line method was used and $18,000 in depreciation was taken, there would be no additional depreciation.

The applicable percentage rules depend on the use of the property, the length of time it was held, and the particular taxable year in which the depreciation was claimed. The computation can be quite complicated, particularly if the property consists of several elements, which can occur if substantial improvements were made.

There are also limitations that postpone depreciation recapture for ordinary income to the extent that you qualify for like-kind exchange gain deferral, involuntary conversion gain deferral, or certain other similar provisions.

Because of the complexity of the depreciation recapture rules, the facts of each taxpayer’s situation may need to be reviewed by a member of our team.

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