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Depreciating Business Equipment – Recapture Income

Recapture Income Can Mean Taking a Tax Hit When You Sell Retiring Assets

Starting and running your own business is no cheap thing.  There’s equipment to buy and maintain, space to rent, people to hire, inventory to stock.  Money just keeps going out the door and sometimes precious little flows in.  So when your accountant told you that on each year’s tax return you could write off a part of the cost of those trucks you had to buy (or the servers, kitchen equipment, lab gear, and most anything else you use to make money) against your income it seemed like manna from heaven.  And it was, too.

But inevitably, after a few years, the day came when you had to sell one of those depreciable assets.  It was old and needed retiring.  New and better ones were available.  So you did sell it but, of course, you got a lot less than you paid for it.

And then, out of nowhere, a big tax bill on the sale appeared.  What’s going on here?

For starters, when you buy depreciable asset you acquire what people in the tax business call a “basis”, which at least in the beginning usually just equals what you paid for it.  After that, every year you depreciated the asset.  That means on your tax return you deducted from income a portion of the asset’s cost.  And because your income went down so did your income tax.

But everything has a price.  In this case, for that bit of tax largess the Internal Revenue Code requires that you write down the original basis by the amount of depreciation taken.  The new amount is called the “adjusted basis” and that’s tax-wise that could cost you, down the road.

For example, suppose that entrepreneur Sally decides to go into business making and selling widgets.  To do this, she buys supplies and a widget-making machine.  The cost of supplies deducts against her income in the year she buys them.

Because the machine wears out a bit at a time, though, Sally can only deduct its cost a bit at a time.  Let’s suppose in the first year she’s allowed a $20,000 depreciation deduction.[1]  So, if in that first year she earned $50,000 after depreciation she only pays income tax on $30,000.  Sweet.

In return for this current tax benefit, Sally writes down her original $100,000 basis in the widget-making machine to an adjusted basis of $100,000 – $20,000 = $80,000.

And now imagine that at the end of year one Sally decides to get out of the widget business and looks around for someone to take the machine off her hands. Lo and behold, up steps a buyer willing to pay her $90,000 for it.  Sally accepts the offer and the sale goes through a year and a day after her original purchase.

Why does the buyer offer so much?  There are various possibilities, including shortages and foolishness.  But the key is that Sally’s depreciation schedule was at best just a guess about the used machine’s market value.[2]  It’s no surprise, really, that projection was off a bit.  In this case the machine was worth more than she expected.  Next time maybe things will go the other way.

What is the taxable gain on this sale?  The same as it ever was: Amount Received less Adjusted Basis.  Sally realizes a gain of $90,000 – $80,000 = $10,000.  The question is, though, what tax rate does she have to apply to this gain (i.e, what is the character of the gain)?

Normally, the gain on selling an asset that was used in a trade or business for more than a year gets the oh so favorable long-term capital gains rate.  But Sally “over-depreciated” her asset, meaning the sales price was greater than her adjusted basis.

As a result, she had already deducted $10,000 more from her ordinary income than was actually warranted by the wear and tear on the widget-making machine.  Before the capital gains rate can apply, Sally first has to “recapture” that excess $10,000.

This means she has to include the $10,000 on her current year’s return as ordinary income, and pay the much higher ordinary income tax rate on it.  Surprise!

If you’re not ready for recapture income it can come as a nasty surprise at tax time.  Whether you’re looking at replacing productive assets or closing up shop altogether you need to consult your tax advisor to get a clear picture of what the tax impacts are going to be.  After all, unless it’s your birthday, nobody really likes surprises.


 

[1] Calculating depreciation is a lot more complicated than this.  For example, there are different methods and lifetimes for categories of equipment.  Here, I’m simplifying so as to focus on the recapture income aspect.

[2] Congress tinkers with depreciation schedules from time to time, too, hoping to spur investment by allowing bigger deductions or raise tax revenues by reducing them.


This article is for informational purposes only and does not constitute legal advice.  You should consult a qualified attorney before taking any action.