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Depreciation Recapture Concepts

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Presentation on theme: "Depreciation Recapture Concepts"— Presentation transcript:

1 Depreciation Recapture Concepts
Speakers: Dawn Polin Senior Manager, Cherry Bekaert LLP Cathy Harris President, Harbor Tax Group

2 Review Recapture Concepts and Rules Take Aways and Discussion
Agenda Review Recapture Concepts and Rules Examples – 4 Scenarios Take Aways and Discussion Questions

3 Why does depreciation recapture exist? What is the purpose!
The preferential LT capital gain rate of 20% was put in place to encourage investment For businesses that buy assets for business use, depreciation comes into play Deprecation is a deduction intended to match benefit with expense. The concept would be; when an asset is fully depreciated it is “used up” (its usefulness matches the expense throughout the asset’s lifetime) When businesses who were allowed depreciation deductions sell an asset at an appreciated price, they are benefiting from the rate difference of these two tax directives Essentially the recapture rules keep taxpayers from saving tax dollars by disallowing the preferential gain rate on the depreciated portion of the gain Depreciation is for assets used in business First consider how depreciation works: Deprecation deductions offset ordinary income The purpose of depreciation is to mimic an asset’s decline in FMV and usefulness

4 Basic Example You purchase a red wagon in 2017 for $500. You take your 179 expense deduction for the entire amount. This gives you a reduction of ordinary income in the amount of $500 and tax savings equal to $ (39.6% tax rate x $500) One year and one day later, you sell this for $500 – the same price you initially paid. Capital gain tax is only $100. (20% of the gain) You saved 20% on taxes automatically! Thus recapture to take away this advantage that would obviously be misused

5 Now Consider a Larger Asset
Assume you build a 10 million dollar building and completed a cost segregation study. With bonus and accelerated depreciation, you were able to take 3 million in depreciation deductions in the first three years saving 1.2 million in tax at a 40% rate. You sell the building after year 3 for 10 million. The capital gain would only be 600K, saving the building owner 600K in tax. Allowing this sort of benefit was not the intention of the IRS, so they introduced depreciation recapture

6 How does recapture work?

7 Review of Income Tax Rates
Top Individual Rate: % Top Corporate Rate: % LT Capital Gain Rates: 20% for individuals 35% for corporations Taxpayers goal would be to get income out of the high ordinary brackets and into the capital gain brackets.

8 Basic Rules of Depreciation Recapture
Recapture is triggered by a sale, exchange or involuntary conversion Applies to depreciation when the sale proceeds exceed the adjusted basis When proceeds exceed the adjusted basis of an asset, the difference will first be allocated to previous depreciation deducted (the recapture portion) and then to capital gain §1245 and §1250 property are not treated the same in recapture In the case of §1250 property, any straight-line depreciation previously deducted, is recaptured at a preferential rate of 25% All accelerated deprecation, §1245 or §1250, is recaptured at ordinary rates, 40% for individuals Instead of proceeds – substitute FMV in the case of an involuntary conversion Adjusted basis = Cost less depreciation to date (Net Book Value)

9 Purchased Office Building
Purchase Price: $2 million, 6 years ago 1250 SL Depreciation = $380,000 Sales Price in 2017 = $2,300,000

10 Initial Investment = $2M
Purchase; no accelerated depreciation Sale Price = $2.3M Appreciation $300K (capital gain) Taxable Gain $680K Initial Investment = $2M Depreciated $380K Depreciation Recapture $380K Adjusted Basis $1.62M Adjusted Basis $1.62M Capital gain = $60K ($300K x 20%) 1250 Recapture = $95K ($380K x 25%) Total tax: $155K No cost segregation Nationwide Service |

11 Initial Investment = $2M
Purchase; with accelerated depreciation Sale Price = $2.3M Appreciation $300K (capital gain) Taxable Gain $1,024K 500K as 15 year 200K as 5 year Initial Investment = $2M Depreciated $724K Depreciation Recapture $724K Adjusted Basis $1.276M Adjusted Basis $1.276M Capital gain = $60K ($300K x 20%) 1245 Recaptures = $79K ($200K x 40%) 1245 Recapture = $77K ($195 x 40%) 1250 Recapture = $82K ($329K x 25%) Total tax: $298K cost segregation The 1250 Property was 150 DDB method and only the SL portion of this is allowed to be recaptured at the preferential rate. Nationwide Service |

12 Cost Segregation Studies & Recapture
Recall that CS studies save tax through time value of money Next we will review the affect of the recapture on the value of the CS Study

13 Summary: Affect of Depreciation No Time Value of Money Consideration
Tax Savings from Depreciation Tax on Sale Savings (Cost) from Depreciation No CS Study $177,839 $94,551 $56,731 With CS Study $353,022 $238,804 $50,956 This chart compares the first 2 example slides. The $60 K tax on the capital gain has been removed to simply the comparison. In this comparison, we have not taken the time value of the original deductions into consideration. It appears the study has actually cost us $5K plus of savings. This is because the 200K of 1245 personal property is not allowed to take the difference between SL and accelerated depreciation into account and only recapture the difference at 40%. All of the 1245 depreciation is recaptured at 40%

14 Summary: Affect of Depreciation With Time Value of Money Consideration
Tax Savings from Depreciation Tax on Sale Savings (Cost) from Depreciation No CS Study $177,839 $94,551 $83,288 With CS Study $353,022 $238,804 $114,218 Now consider our outcome when we consider the future value of the depreciated deductions. In our example, we have used the Future Value of Money at 5% to show true savings. The outcome is quite a bit different. We need to make sure client / taxpayers understand the benefits.

15 Initial Investment = $2M
Purchase; with accelerated depreciation; all 1250 recapture qualifies for 25% rate Sale Price = $2.3M Appreciation $300K (capital gain) Taxable Gain $1,024K 500K as 15 year 200K as 5 year Initial Investment = $2M Depreciated $724K Depreciation Recapture $724K Adjusted Basis $1.276M Adjusted Basis $1.276M Capital gain = $60K ($300K x 20%) 1245 Recaptures = $79K ($200K x 40%) 1250 Recapture = $131K ($524K x 25%) Total tax: $270K The 1250 Property was all SL so received the preferential rate of 25%. The 1245 deprec was recaptured at ordinary rates. Nationwide Service |

16 Initial Investment = $2M
Purchase; with accelerated depreciation; all 1250 recapture qualifies for 25% rate & no value in the 1245 assets Sale Price = $2.3M Appreciation $300K (capital gain) Taxable Gain $1,024K 500K as 15 year 200K as 5 year Initial Investment = $2M Depreciated $724K Depreciation Recapture $724K Adjusted Basis $1.276M Adjusted Basis $1.276M Capital gain = $100K ($500K x 20%) 1245 Recaptures = $0K ($0K x 40%) 1250 Recapture = $131K ($524K x 25%) Total tax: $231K The 1250 Property was all SL so received the preferential rate of 25%. It was determined the 1245 property had no value on the sale. Nationwide Service |

17 Summary: Affect of Depreciation
Tax Savings from Depreciation Tax on Sale Savings (Cost) from Depreciation No CS Study $177,839 $94,551 $83,288 With CS Study $353,022 $238,804 $114,218 15 year is all 1250 $210,000 $142,722 Zero value to 1245 $171,000 $181,922 This chart adds the last two scenarios to the comparison. This chart shows the last two slides we walked through as “All 39 year” and Example 2. Example 3 has the same cost segregation facts as 2 except when we recaptured our 15 year property we considered it all 1250 property and applied the preferential 25% rate Example 4 builds on this further by also assuming that the 5 year property was worthless therefore was not allocated any of the sale proceeds on purchase. Therefore, we did not recapture any depreciation deductions at the higher ordinary income rate in this example. This amount increased the 1231 gain. (we have reduced the tax on sale by only the same 60k as the other examples to keep it consistant) As you can see, these two planning considerations have great results.

18 Takeaways When a building is sold, the value of accelerating depreciation can be diminished or eliminated if planning is not carefully considered What can we do to mitigate the pinch of recapture for our clients when they sell real estate?

19 Discussion What can be done during a cost segregation study to mitigate the effect of recapture on sale, if anything? Is it common practice to value 1245 property that is fully depreciated at zero? If so, does this bar the purchaser from completing a CS study on the same property and allocating value to short life assets? Consider that recapture is also required for 179D deductions. Do you think this is practical?

20 Planning Remember expensing keeps line items off the balance sheet so recapture is never on the table Partial Dispositions Remove old assets from the depreciation schedule

21 Questions?


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