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?