As property depreciates, its value declines. When depreciated assets are sold, it’s able to be filed as ordinary income as long as the transaction’s price is above the property’s adjusted cost basis. The gap between the sales price and its adjusted cost basis must be filed as a component of the individual’s ordinary income.
Adjusted Cost Basis = Asset’s Purchase Price + Improvements – Depreciation Deductions
Per Internal Revenue Code Section 1016, this calculation factors in both lower depreciation rates and improvement additions, resulting in the asset’s net cost.
If an asset purchase price is $75,000, and it’s depreciated annually over six years, its adjusted cost basis is as follows: $75,000 – ($3,000 x 6) = $57,000.
If, however, the asset is sold for less compared to its adjusted cost basis, the transaction’s gain should be filed as a capital gain and not ordinary income. When it comes to calculating depreciation recapture, the adjusted cost basis is incorporated into the calculation as follows: Â
Property Acquisition Cost: $750,000
Six annual deductions for depreciation: $7,000
Amount the assets are sold for in year 7: $740,000
Tax Rate of 25 percent for depreciation recapture
20 percent tax rate of capital gains
Therefore, adjusted cost basis equals = $750,000 – ($7,000 x 6) = $708,000
When calculating the gain on the sale, the resulting amount is calculated as follows:
= $740,000 – $708,000 = $32,000
Based on the owner(s) of the assets, the $32,000 will be reported as ordinary income. The depreciation recapture tax of 25 percent on the $32,000 will be $8,000 ($32,000 x 25 percent).
Be mindful if the $32,000 is more than the full depreciation deductions filed for by the taxpayer, the depreciation recapture will match how much depreciation is deducted and must be taxed as ordinary income. The balance will be taxed as a capital gain.
Assume everything from the first calculation is the same, but now the same asset is sold for $940,000.
Property Acquisition Cost: $750,000
Six annual deductions for depreciation: $7,000
Amount the asset is sold for in year 7: $940,000
Tax Rate of 25 percent for depreciation recapture
20 percent tax rate of capital gains
The adjusted cost basis will remain $708,000
In this example, since the asset owner’s gain is $190,000 ($940,000 – $750,000), only the depreciation deduction of $42,000 ($7,000 x 6 years of depreciation) will be reported as ordinary income since it’s the complete sum of the depreciation deductions. The balance of $148,000 ($190,000 – $42,000) will be taxed at the capital gains rate. The calculations for taxes are calculated as follows:
Depreciation recapture: $42,000 x 25 percent = $10,500
Capital gains calculation: $148,000 x 20 percent = $29,600
It’s important to consider that if an asset has been held for fewer than 12 months, gains from property sales are taxed as ordinary income. Depending on the circumstances, if an asset is sold for a loss, depreciation recapture isn’t applicable; however, Internal Revenue Code Section 1231 may provide exceptions to treat it as an ordinary loss tax treatment.
While each business’ transactions are different, when the entity is eligible, it can provide another way to navigate their federal taxes efficiently. As always, contact a professional for more personalized guidance.
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"; html += ""; html += "As property depreciates, its value declines. When depreciated assets are sold, it’s able to be filed as ordinary income as long as the transaction’s price is above the property’s adjusted cost basis. The gap between the sales price and its adjusted cost basis must be filed as a component of the individual’s ordinary income.
Adjusted Cost Basis = Asset’s Purchase Price + Improvements – Depreciation Deductions
Per Internal Revenue Code Section 1016, this calculation factors in both lower depreciation rates and improvement additions, resulting in the asset’s net cost.
If an asset purchase price is $75,000, and it’s depreciated annually over six years, its adjusted cost basis is as follows: $75,000 – ($3,000 x 6) = $57,000.
If, however, the asset is sold for less compared to its adjusted cost basis, the transaction’s gain should be filed as a capital gain and not ordinary income. When it comes to calculating depreciation recapture, the adjusted cost basis is incorporated into the calculation as follows: Â
Property Acquisition Cost: $750,000
Six annual deductions for depreciation: $7,000
Amount the assets are sold for in year 7: $740,000
Tax Rate of 25 percent for depreciation recapture
20 percent tax rate of capital gains
Therefore, adjusted cost basis equals = $750,000 – ($7,000 x 6) = $708,000
When calculating the gain on the sale, the resulting amount is calculated as follows:
= $740,000 – $708,000 = $32,000
Based on the owner(s) of the assets, the $32,000 will be reported as ordinary income. The depreciation recapture tax of 25 percent on the $32,000 will be $8,000 ($32,000 x 25 percent).
Be mindful if the $32,000 is more than the full depreciation deductions filed for by the taxpayer, the depreciation recapture will match how much depreciation is deducted and must be taxed as ordinary income. The balance will be taxed as a capital gain.
Assume everything from the first calculation is the same, but now the same asset is sold for $940,000.
Property Acquisition Cost: $750,000
Six annual deductions for depreciation: $7,000
Amount the asset is sold for in year 7: $940,000
Tax Rate of 25 percent for depreciation recapture
20 percent tax rate of capital gains
The adjusted cost basis will remain $708,000
In this example, since the asset owner’s gain is $190,000 ($940,000 – $750,000), only the depreciation deduction of $42,000 ($7,000 x 6 years of depreciation) will be reported as ordinary income since it’s the complete sum of the depreciation deductions. The balance of $148,000 ($190,000 – $42,000) will be taxed at the capital gains rate. The calculations for taxes are calculated as follows:
Depreciation recapture: $42,000 x 25 percent = $10,500
Capital gains calculation: $148,000 x 20 percent = $29,600
It’s important to consider that if an asset has been held for fewer than 12 months, gains from property sales are taxed as ordinary income. Depending on the circumstances, if an asset is sold for a loss, depreciation recapture isn’t applicable; however, Internal Revenue Code Section 1231 may provide exceptions to treat it as an ordinary loss tax treatment.
While each business’ transactions are different, when the entity is eligible, it can provide another way to navigate their federal taxes efficiently. As always, contact a professional for more personalized guidance.
DisclaimerÂ
These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact a professional regarding the topics in these articles. The images linked to these articles are protected by copyright and should not be copied for any reason.
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