Tom Talks Taxes - February 19, 2021

Four reasons why depreciation is a valuable tax deduction

Depreciation: Often Misunderstood

I often hear taxpayers and tax professionals alike question the value of the depreciation deduction because the taxpayer ultimately “pays it back.” Here are four reasons why this belief is often incorrect:

Reduced gain upon sale. Depreciation is a deduction for the wear and tear on an asset. When a taxpayer sells a depreciated asset, the sale price is generally less than the purchase price. This means any depreciation recapture upon sale is generally less than the total depreciation taken.

Here’s a quick example: a taxpayer purchases equipment for $10,000 and fully expenses it with 100% bonus depreciation. Five years later, the taxpayer sells it for $3,000. The gain recognized on the sale is $3,000 ($3,000 received less $0 adjusted basis) and the gain is §1245 depreciation recapture, subject to ordinary income tax rates. Assuming the taxpayer is in the 24% bracket in the year of purchase and sale, the taxpayer saved $1,680 in federal tax on the $7,000 of depreciation not recaptured due to the decrease in the equipment’s value.

Inherited assets. When a taxpayer inherits an asset, the basis resets to the fair market value on the date of the original owner’s death. The prior accumulated depreciation is wiped away and there is no later tax cost due to the depreciation taken previously.

Another quick example: Fred owns a rental property with $100,000 in accumulated depreciation. He dies and his son inherits the property, and at the time of death the building portion is valued at $500,000. Assuming Fred’s son continues to rent the property, his adjusted basis in the building resets to $500,000, and there is no unrecaptured §1250 gain due to the previously claimed depreciation.

Rate differential. A taxpayer may pay a lower tax rate on any gain attributable to depreciation than the tax rate at which the depreciation was originally deducted.

Unrecaptured §1250 gain, applicable to depreciated real property, is subject to tax at a maximum 25% capital gains rate, while the depreciation deduction that gave rise to the unrecaptured §1250 gain may have been taken at a higher ordinary tax rate.

Time value of money. Money that a taxpayer has now from a depreciation deduction is worth more than the identical sum in the future due to its potential earning capacity. Here’s an article that gives a solid overview of the concept.

Do not skip depreciation — not only is it required, but it also increases the taxpayer’s net worth long-term. If a taxpayer did not take the required depreciation deduction in the past, then the taxpayer can usually file Form 3115, Application for Change in Accounting Method, on an original tax return and take a one-time §481(a) adjustment to claim all prior depreciation erroneously omitted.


Articles I Recommend

Jack Salewski and Paul Hamann have a great blog post on things to consider when making reasonable compensation decisions for a business owner with more than one S corporation.

Kelly Phillips Erb dispels common tax myths in Top Twenty Tax Myths and Why They’re Wrong—Part 1 and Top Twenty Tax Myths and Why They’re Wrong—Part 2.

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Oregon Assoc. of Tax Consultants, Westside Chapter - February 22, 2021 (virtual)

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