Capital Gains tax is something that most business owners and investors are familiar with. However, there is a lesser-known tax for which business owners and investors should plan. What happens if an asset is deprecated, and what is depreciation recapture tax (DRT)?
Depreciation Recapture Tax is a concept in the US tax code that pertains to the taxation of gains resulting from the sale of certain assets, such as real estate or business property, which have already been depreciated for tax purposes. To understand Depreciation Recapture Tax, it’s essential to grasp the basics of depreciation.
Depreciation is when a taxpayer acquires an asset, such as a building or machinery, and allocates a portion of its cost as a depreciation expense over its useful life, allowing them to recover the asset’s cost gradually, reflecting the wear and tear it undergoes.
However, when the asset is sold, the IRS requires recapturing some or all the previously claimed depreciation. The Depreciation Recapture Tax rate is typically 25% for real property and personal property used for trade or business. However, it can be as high as 28% on the sale of residential rental property.
The tax applies to the lesser of the gain realized on the sale or the amount of depreciation previously claimed. For example, suppose a taxpayer claimed $50,000 in depreciation on a property with a total cost of $200,000. If they sell the property for $300,000, the gain is $100,000 ($300,000 – $200,000). Thus, the Depreciation Recapture Tax would apply to the $50,000 of depreciation claimed. The taxpayer would owe $12,500 in Depreciation Recapture Tax (25% of $50,000). However, it’s important to note that not all assets are subject to Depreciation Recapture Tax.
Personal-use property, like a primary residence, is generally exempt. Additionally, certain small business assets may qualify for Section 179 expensing or bonus depreciation, which can affect the amount of depreciation subject to recapture. To mitigate the impact of the Depreciation Recapture Tax, taxpayers can explore strategies such as like-kind exchanges (under Section 1031) or investing in Qualified Opportunity Zones. These strategies allow for the deferral or reduction of capital gains taxes, including those related to depreciation recapture.
In conclusion, Depreciation Recapture Tax is a mechanism that ensures taxpayers pay taxes on the economic gain derived from the sale of assets for which they previously claimed depreciation. Understanding the rules surrounding Depreciation Recapture Tax is crucial for individuals and businesses engaging in the sale of depreciable assets, as it can significantly impact the overall tax liability associated with such transactions.
If you have a situation that requires depreciation tax, reach out to an empiriKal partners advisor. They have various strategies that will allow you to mitigate the lesser-known Depreciation Recapture Tax.
Investing involves risks, and investment decisions should be based on your own goals, time horizon, and risk tolerance. The return and principal value of investments will fluctuate as market conditions change. When sold, investments may be worth more or less than their original cost. Past performance does not guarantee future results. The information in this material is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and content provided are for general information. This is not a solicitation for the purchase or sale of any security.
