Depreciation For Your Business and Rental Property

Depreciation is simply the allocation of the cost of the asset over a statutory period of time. The business car, for example, has a five-year statutory life. IRS publications give you percentages to deduct each year.

If you sell the car for more than its basis, you have ordinary income treatment on the portion of the profit attributable to depreciation.If you fail to claim the deprecation, the law takes it for you and treats you as if you had taken it.  To the extent of gain, some depreciation is taxed at a special 25% tax rate. 

Claim Your Depreciation

Many taxpayers say they did not claim depreciation because they did not need the deduction.  Claim your depreciation. The law requires that you claim depreciation. If you fail to follow the law, the law punishes you.

 Example:  You should have claimed $10,000 in depreciation of a property that you own and use as a rental.  You did not need the deduction, so you claimed nothing.  The IRS audits your return and finds the unclaimed depreciation.  The law prohibits the IRS from giving you this audit-identified deduction.  By law, you are deemed to have taken the deduction.  You are taxed as if you had taken the deduction.

If you are in the 35% tax bracket, you taxes will work like this:  First, you lose the $10,000 deduction, which costs you $3,500.  Second, the law taxes you as if you had taken the deduction.  Thus, your $10,000 phantom deduction is taxed at 25% under the deprecation-recapture rules.  That costs you another $2,500. 

 If you have unclaimed depreciation, fix it this very moment.  The fact that you don’t pay a fee to the IRS to file the form does not mean you’re going to get off scot-free.  You’re not going to like Form 3115; it’s pretty much designed for tax preparers only.

Consider Ordinary Income Recapture When you Sell Furniture and Equipment

 Say you bought a SUV in 2003 for $40,000 and wrote off the entire $40,000 cost using section 179 expensing. If you sell the SUV today for $15,000, you have a $15,000 gain, because expensing reduced your adjusted basis to zero.

 This is not a tax-favored capital gain, because the gain is due solely to your depreciation write-off.  To the extent a gain from the sale of personal property is due to depreciation, you pay tax at ordinary income rates.

 Planning tip:  Before you dispose of personal property, consider recapture and, if necessary, make a plan.  For example, with this SUV, you could defer the taxes with a section 1031 exchange.

Consider the 25% Depreciation-Recapture Tax When You Sell Real Property

 Years ago, straight-line depreciation on real property turned into capital gain when you sold the property.  Today, the law still considers the gain attributable to straight-line depreciation as capital gain, but it does not allow the tax-favored 15% rate.  Instead, lawmakers give you a 25% depreciation-recapture rate.

 Example:  You buy a rental property for $300,000, depreciate it $100,00, and sell it for $400,000.  Your adjusted basis at the time of sale is $200,000 ($300,000 original cost minus $100,000 depreciation). You total gain is $200,000 ($400,000 sales proceeds minus $200,000 basis).  On this $200,000 gain you will pay.

• 15% on the $100,000 of pure capital gain (gain in excel of cost), and
• 25% on the $100,000 of depreciation-recapture gain.

Planning tip #1:  You can defer the taxes on this real property with a section 1031 exchange.

Planning tip #2:  When evaluating rental property returns, always consider annual cash inflows and outflows on an after-tax basis.

Beware of the Special Five-Year Look-Back Rule

Assets used for more than one year in your business or with your rental properties qualify for tax-favored section 1231 treatment.  Section 1231 is very beneficial.  It gives you the best of both worlds by:

• Taxing net section 1231gains at tax-favored long-term capital gains rates, and
• Treating net section 1231 losses as ordinary losses.

If you are in the 35% tax bracket, you benefit from section 1231 by:

• Paying a 15% capital gain tax on net gains, or
• Receiving a 35% cash benefit on net losses.

Beware of the five-year look-back rule.  It can destroy your section 1231 benefit by turning your capital gains into ordinary income.You need to know this rule so you can plan your business property sales to avoid losing your capital gains benefits.

The look-back rule works like this:  Your current-year section 1231 net gain is treated as ordinary income (not capital gain) to the extent that you have benefited from section 1231 losses during the past five years.  Say you look back over the past five years and find that you had section 1231 losses of $21,000.  If you have a $35,000 section 1231 net gain this year, you must treat $21,000 of the $35,000 gain as ordinary income.

The favorable 1231 treatment does not alter the treatment of gains subject to depreciation-recapture rules:

• Gains treated as ordinary income under the recapture rules, like gains attributable to deprecation on the sale of personal property, are excluded from the 1231 netting process.
• Gains subject to the 25% depreciation-recapture tax, like gains of the sale of rental properties, remain subject to the 25% recaptures tax.

Eight Things to Remember About Depreciation

1. You must claim depreciation or the law will take it for you and then tax you as if you had taken it.
2. Depreciation can be recaptured and treated as ordinary income to the extent of the gain.
3. Depreciation can be subject to the depreciation-recapture tax.
4. Tax-favored long-term capital gain comes fro an asset you own for more than a year and that you sell for more than you paid for it.
5. Your adjusted basis for tax purposes is original cost plus improvements minus depreciation.
6. Depreciation is based on legislation, which may or may not be reasonable.
7. Section 1231 transactions are sales of business or rental property held longer than one year.
8. Because you have to consider depreciation for tax purposes, the gain or loss you have for tax purposes are far different from the gain or loss you have by simply comparing purchase price with sale proceeds.