Tax benefits from depreciation may sound very familiar with many of us. Depreciation is one of the most advantageous deductions because it reduces taxable income but doesn’t reduce your cash flow. Depreciation can lead to valuable income tax deductions that may save you thousands of dollars per year. However, have you heard of the term ‘depreciation recapture’. For some of us who have not known about depreciation recapture who benefited from depreciation of a section 1245 property, be aware that the IRS might want some of that money back when you sell.
1. What are considered as 1245 properties?
Section 1245 property includes any property that is or has been subject to an allowance for depreciation or amortization and that is any of the following types of property.
- Personal property (either tangible or intangible).
- Other tangible property (except buildings and their structural components) used in many activities which are further discussed by the IRS.
- Single purpose agricultural (livestock) or horticultural structures.
- Storage facilities (except buildings and their structural components) used in distributing petroleum or any primary product of petroleum.
- Any railroad grading or tunnel bore.
A few examples of 1245 properties are: furniture and fixtures in a rental property or machinery in a plant. Note that Section 1245 properties do not include buildings and structural components.
2. Depreciation recapture and tax impacts
2.1 Gain realized when selling 1245 assets treated as ordinary income
Upon a sale of Section 1245 asset:
- The lesser of gain realized or amounts previously claimed as depreciation (allowed or allowable) is recaptured as ordinary income under Section 1245. The gain realized on the disposition is the amount realized from the disposition minus the adjusted basis of the property.
- Any remaining gain is a Section 1231 gain and taxed at capital gains tax rate.
2.2 Depreciation and amortization being recaptured
Depreciation and amortization being recaptured as ordinary income include but are not limited to: ordinary depreciation deductions, special depreciation allowance you claimed, amortization deductions for many types of costs (further discussed by the IRS), Section 179 deductions, any basis reduction for the investment credit, any basis reduction for the qualified electric vehicle credit.
2.3 Example
In 2021, you bought and placed in service for 100% use in your business an equipment that cost $10,000. You sold the truck in 2023 for $7,000.
Amount sold for $7,000
Cost $10,000
Depreciation allowed or allowable $6,000
Adjusted basis $4,000
Gain realized $3,000
Gain treated as ordinary income $3,000
Gain treated as Section 1231 gain $0
2.4 Minimize tax impacts from depreciation recapture
If you want to reduce the amount of depreciation recapture prompted from a disposal of business assets and minimize the tax impacts you will need advanced tax planning.
In general, when we depreciate an asset quickly, the adjusted basis will be reduced more quickly and we will have more taxable gain on the sale. The faster you depreciate a business asset, the more likely that you would have a recapture liability in the future when you sell the asset. When we have a recapture in a profit year, the recapture can increase our taxable income and possibly move us into a higher tax bracket.
If you think you may not hold the asset for long and will sell it in the near future, you should consult your tax professional on how to minimize the tax impacts from the future disposition.
3. Conclusion
When it comes to assets, it’s important to do your research about the depreciation guidelines set by the IRS and the tax complication of asset disposition. This will give you a better idea of both your potential tax deductions and future tax bills.
Always consult a qualified tax professional when keeping in mind tax laws are complicated and change periodically. You’ll want to be advised about the pending tax liabilities and potential strategies to reduce or defer taxes.