Depreciation is one of the more useful things in the tax code and one of the most commonly mishandled, because people focus entirely on the deduction and not at all on what happens when the asset leaves.
The basic idea
An asset used in a business is deducted over its useful life rather than all at once, because it produces income over years rather than in one. That is depreciation. Section 179 and bonus depreciation are provisions that let you accelerate a great deal of it into the year of purchase.
Where recapture comes in
When you sell the asset, the gain is calculated against your adjusted basis — original cost minus the depreciation you took. If you deducted most of the cost in year one, your basis is near zero, and almost the entire sale price is gain.
Worse, the portion attributable to depreciation you claimed is generally taxed as ordinary income rather than at capital gains rates. That is recapture, and it is the surprise that catches people who accelerated everything and then sold a truck three years later.
Why "take the biggest deduction" is not always right
- If you are in a low bracket this year and expect to be in a higher one later, accelerating the deduction wastes it at the low rate and creates ordinary income later at the high one.
- If the asset will be sold within a few years, the recapture arrives soon and undoes much of the benefit.
- Section 179 has business income limitations that can leave part of the deduction unusable in the year taken.
- Vehicles have their own limits and their own recapture rules if business use drops below a threshold in a later year.
The vehicle trap specifically
If you claim accelerated depreciation on a vehicle and business use later falls below 50 percent, you have to recapture part of what you took. That catches people who bought a truck for a business that then changed shape.
Rental property
Residential rental property is depreciated over a long period whether or not you claim it — and this is the part that genuinely surprises people. When you sell, basis is reduced by depreciation allowed or allowable. If you never claimed it, you still lose the basis. That is why properly tracking depreciation on a rental from day one matters even to an owner who is not currently benefiting from it.
What to do
Decide the depreciation strategy with the exit in mind rather than only the current year. On equipment you expect to hold for its full life, accelerating is frequently right. On something you will trade in three years, it frequently is not.
This is exactly the kind of decision that has to be made during the year and cannot be fixed in April.
This article is general information, not tax advice, and tax rules change from year to year. Confirm current-year figures and talk with a professional about your specific situation before acting.
Common questions
What is depreciation recapture?
When you sell a depreciated asset, the portion of the gain attributable to depreciation you claimed is generally taxed as ordinary income rather than at capital gains rates. It is why accelerating depreciation on an asset you will sell soon can undo much of the benefit.
Should I always take Section 179 or bonus depreciation?
No. It depends on your current bracket versus your expected future bracket, how long you will hold the asset, and whether you have enough business income to use the deduction. Taking the largest deduction available is a default rather than a strategy.
What if I never claimed depreciation on my rental?
Your basis is still reduced by the depreciation that was allowable, whether or not you claimed it. That means you lose the deduction and still pay the recapture. It is worth correcting, and there are procedures for doing so.
Have a question about your situation?
Robert prepares returns for individuals, contractors, and small business owners across Weatherford, Aledo, Willow Park, Springtown, Mineral Wells, and the rest of Parker County. Bring your questions — the first conversation is free.