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.
I’m often asked to consult with colleagues on client matters. Due to this demand, I’m expanding my capacity to do paid consultations. I am also starting a monthly subscription program for tax professionals who want an ongoing consulting relationship. You can see the details and sign-up information on my website.
My Upcoming Education Events
Compass Tax Educators, of which I am a co-owner, is offering its annual all-access pass for all live webinar events from May 1, 2021 through April 30, 2022. We guarantee we will offer at least 30 CE/CPE. You can see the courses planned and purchase a pass here.
As part of the entire package, I’ll be teaching any “breaking news” events due to new tax law plus eight scheduled classes.
Oregon Assoc. of Tax Consultants, Westside Chapter - February 22, 2021 (virtual)
PPP Loan Tax Issues and the Employee Retention Credit (2 CE)
Virginia Society of Enrolled Agents Spring Seminar - June 2-4, 2021 (virtual)
Introduction to IRS Representation (2 CE)
Arizona Society of Enrolled Agents Southwest Fest - June 14-16, 2021
Topics to be announced