Beware of
Recapture Rules When Gifting Depreciated Property
A simple thing like
giving your business car to your child triggers a
minefield of potential tax problems.
In fact, the gift of the car, and
various other assets, can effectively destroy big
tax benefits. Say the IRS showed up and
found that you owed $10,000 in taxes because you
gave the wrong business assets to your child or
spouse, you would not be a happy taxpayer.
This article will help you design
your gifting program so that you get the benefits
you desire. It will help you avoid the big
traps that lawmakers have set down for the past
20 years.
When you make gifts of personal
property, like cars and furniture, you need to
consider three types of recapture:
1. Depreciation recapture
2. Section 179 expensing
3. Section 280F
business-use recapture
When a gift triggers a recapture,
something happens, either to you or to the gift
recipient. Sometimes this happening is
tragic, but not with no-problem gifts.
No-Problem
Gifts
When you gift personal property,
other than listed property discussed later, on
which you did not claim Section 179 expensing,
you are making a “no-problem” gift for
income tax purposes.
In general, the no-problem gift
transfers the asset and your basis to the gift
recipient. With no-problem gifts neither
you nor the recipient has to worry about income
taxes at the time of the gift.
Example: Twelve years ago,
you paid $3,000 for your business desk and
depreciated it to zero in your business.
Today when the desk has a value of $1,200, you
give it to your 18-year-old son.
Your gift of the desk triggers no
depreciation recapture for you. Also,
because your gift of property has a value of
$11,000 or less, you do not need to consider gift
taxes. For you, this is a no-problem gift.
Your son receives this
$1,200 desk at your depreciated tax basis of
zero. When your son sells this desk, he
will measure gain using your zero basis.
With this gift, your son steps into your shoes as
to basis for calculating depreciation, and gain
on sale.
Because your son is now in your
shoes, any sale of this desk up to your original
basis of $3,000 will represent ordinary income to
your son, just as it would represent ordinary
income to you.
Example: Your son uses the
desk for personal purposes for several years and
then sells the desk for $1,015. The $1,015
is taxable ordinary income to your son in the
year of sale.
The fact that the sale of the desk
by your son generates taxable income is no big
deal for five reasons:
1. The sale of the desk
is not subject to self-employment taxes.
2. Your child may be in a
lower tax bracket than you, giving your family
the benefits of income splitting.
3. Your child might never
sell the desk and, thus, never pay taxes on the
desk.
4. Your child might use
the desk forever, or until the desk is used up
and worthless.
5. Your child might keep
the desk until death, at which time the desk
passes to his heirs at its fair market value,
with no tax on its depreciated basis.
For your son, as it was for you,
this desk is a no-problem gift.
Planning tip: When
giving personal property assets that you used in
your business, look for the no-problem assets,
like this desk.
Identifying a “no-problem
asset”: The no-problem business asset is
that asset you have fully depreciated, and whose
depreciation life has expired.
Listed
Property – Potential Problem Assets
Your “listed property”
includes
· any passenger
automobile,
· any other
property used as a means of transportation
· any property of a
type generally used for purposes of
entertainment, recreation, or amusement,
· any computer or
peripheral equipment, and
· any cellular telephone
(or similar telecommunications equipment).
Exception for certain computers:
Your “listed property” does not include
any computer or peripheral equipment used
exclusively at one of your regular business
establishments, including your deductible home
office.
Why a problem: You must
keep your business use of listed property at more
than 50% to keep your accelerated and bonus
depreciation deductions. When you fail the
“more-than-50%” test for any reason,
you have to pay back your accelerated
deductions. The listed property recapture
rules operate separately and independently from
the gift rules.
In other words, when you make a
gift of listed property, your business use of
that asset drops to zero and that triggers
recapture of your accelerated and bonus
deductions.
Example: You paid $40,000
for an SUV that the law exempts from the luxury
car limits. You did not claim Section 179
expensing, discussed below, but you did claim 50%
bonus depreciation and 20% MACRS depreciation in
the first year for a write off of $24,000.
In Year 2, you give this SUV to
your mother. This drops your business use
to zero. You must recomputed your
first-year deduction using the straight-line
depreciation method which gives you a $4,000
first-year deduction (10% of $40,000).
Next, you pay taxes on recapture income of
$20,000 ($24,000 minus $4,000). This is
bad!
Special rule on gifts to
spouses: If you give the SUV to your spouse,
you do not have to recapture your accelerated or
bonus depreciation of listed property.
Instead, the law transfers the SUV to your spouse
with your basis and your business use. If
your spouse does not use the SUV for business
more than 50% of the time, your spouse pays the
recapture tax. This is also bad!
Planning tip: When making a
gift of any listed property, calculate the
recapture impact before making the gift.
Keep in mind that once the ADS straight-line
depreciation life expires, the recapture problem
for listed property disappears. For
example, with the SUV, the recapture problem
disappears in the sixth year of business
use. Good news! Thus, in the sixth
year, SUVs make great gifts.
Assets
Expensed Under Section 179 – Another Problem
for Gifts
You may qualify to expense all or
part of a business asset under Section 179 of the
Internal Revenue Code. If so, you have
choices:
· Depreciate the
asset,
· Expense the
asset, or
· Expense part of
the asset and depreciate the balance.
If you choose to expense all or
part of the asset, you make a deal with the
government that you will keep your business use
greater than 50% during the asset’s life
which
· for listed
property is the ADS statutory life used for
alternative minimum tax purposes (longest life),
and
· for nonlisted
property is the MACRS statutory life used for
regular tax purposes (shortest life).
For example, office furniture,
which is not listed property, has a ten-year life
for ADS, and seven-year life for MACRS.
Since office furniture is not
listed property, you look to the seven-year life
for purposes of keeping your business use over
50%. Further, you may use accelerated
depreciation (MACRS) to calculate recapture when
you fail the 50% test.
Example: You spend $20,000
on office furniture this year and expense it all
using Section 179 expensing. Next year, you
give this office furniture to your 19-year-old
college student. The gift triggers
recapture for you.
Thus, you must recompute your
first year deduction. In this case, you may
use MACRS, the fastest depreciation. You
pay the recapture tax on the difference between
the $20,000 first year expensing and the first
year MACRS depreciation. Your
student’s basis in the furniture is your
basis, after your adjustment for recapture.
Gifts to spouse: Had you
given the furniture to your spouse, your spouse
would jump into your shoes with respect to the
furniture. If your spouse does not use the
furniture more than 50% for business use, your
spouse must pay the recapture tax.
The Lost Loss
Problem
This article focuses primarily on
depreciation recapture when you make a
gift. You also want to avoid making gifts
of assets that would produce a tax loss for you
if you sold them.
When you make a gift of an asset
on which you could have claimed a tax loss, you
more than likely send your tax loss to
never-never land. This is very bad.
Let’s say you are going to
give some assets to your daughter. When
your daughter goes to sell the assets that you
gave her, she computes
· gain by
comparing your basis with net sale proceeds, and
· loss by
comparing the lower of your basis or fair market
value with sales proceeds.
Example: You bought an
asset for $50,000 and depreciated it
$30,000. The asset’s adjusted basis is
$20,000. You consider giving this asset to
your daughter. The asset has a fair market
value of $5,000.
Option 1: If you sell the
asset for its $5,000 fair market value, you will
have a deductible loss of $15,000 ($5,000 sales
proceeds minus $20,000 basis).
Option 2: You give the
asset to your daughter who sells it for
$5,000. She has a zero loss ($5,000 sales
proceeds minus $5,000 loss basis –
lower of your basis or fair market value on date
of gift). Thus, by giving this asset to
your daughter, you toss your $15,000 loss
deduction in the trash.
Unlikely, but possible option
3: A miracle happens and your daughter sells
this asset for $32,000. Her basis for gain
is $20,000 (your basis). Thus, she has an
ordinary income taxable gain of $12,000 ($32,000
sales proceeds minus $20,000 basis.
Planning note 1: Your
daughter realizes ordinary income to the extent
that you previously took depreciation
deductions. Or to put this another way,
your daughter will not have capital gain on the
sale of this asset until the sales price exceeds
your original $50,000 basis. This gain on
sale produces the same result for your daughter
as it would have produced for you had you sold
the asset, instead of gifting it to her.
Planning note 2: In select
circumstances, your daughter may use your lost
loss. If she sells the asset for more than
$5,000 and less than $20,000, she is in your loss
range. To the extent of her profit in your
loss range, she may use your lost loss to offset
her profit. For example, say your daughter
sells the above asset for $10,000. She has
a $5,000 profit which can offset using $5,000 of
your $15,000 lost loss; therefore, she has no
tax.
Planning note 3: Do not
make gifts of assets on which you could claim a
tax loss.
Summary
Don’t make exciting
gifts. Gifts are exciting when neither you
nor the recipient knows the rules. Know the
tax results before you make gifts.
When making gifts of business
assets, start with no-problem assets.
Remember, these are assets that are
· fully depreciated, and
· out of life.
No-problem assets lack excitement
and make you smile because these assets have
· no recapture
problems, and
· no loss-on-sale
problems (no throwing your money in the trash
part).
Therefore, keep your nerves at
rest. Make gifts of no-problem assets.
Your Section 179 expensing and
listed property assets also pose zero problems if
their lives are over. At that point, the
assets are fully depreciated and you have no
recapture problems. In substance and in
fact, the “lives-are-over” group is a
no-problem group.
Remember, the listed property life
for 50% or less business use may be longer than
the life you use to depreciate the asset for
regular tax purposes. So, if the item you
want to give away is listed property, check the
ADS straight-line depreciation life.
With proper planning, you can
accomplish much with gifts. For example,
gifts allow you to
· find a
lower family tax bracket for the sale of the
asset,
· move your
assets to children who need money for college,
· move the
assets to your parents who may need money for
retirement,
· stop giving
away your after-tax money and create a
gift-leaseback strategy with your children,
parents, and others to whom you currently give
money.
With improper planning, you can
create some terrifying tax consequences.
You do not want excitement in your tax life!
Therefore, the golden rule:
Gift only after you know the tax consequences of
the gifts.
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