Depreciation is a method of recovering the cost of an asset as an annual income tax deduction. The deduction is allocated over the useful life of the asset, as determined by the IRS. When you stop using an asset for business purposes, whether by converting it for personal use or by selling it, you might have to recapture some of the depreciation expense. You will treat the recapture amount as ordinary income. The amount will depend on the gain and on the depreciation that was allowed or allowable up to and including the year it was disposed of.
If you depreciate your asset under the modified accelerated cost recovery system (MACRS), you will calculate depreciation recapture when your business disposes of the asset for a gain. You have a gain if the asset is sold for more than its adjusted basis or the amount of the asset's cost that has not yet been recovered through allowed or allowable depreciation expense. You are only subject to recapture of gains up to the amount of depreciation that was allowed or allowable.
The term "allowed or allowable" in the IRS regulations regarding recapture can be a source of confusion. The "allowed" depreciation is what was taken on the tax return. The "allowable" portion is the amount of depreciation that should have been taken, regardless of whether or not it was used. It doesn't seem fair that you should have to recapture a depreciation deduction that you didn't take. The IRS recognizes this so the depreciation limit includes only the allowed depreciation as long as the taxpayer can show adequate records. However, the allowable depreciation comes into play when adjusting the basis to calculate the gain limit, regardless of what was allowed.
Calculate the depreciation that was allowable for all years including the year you sold the asset. Add this back to the basis of the asset, then find the difference between the selling price and the basis. Examine the depreciation that was allowed, including in the year of disposal. The depreciation recapture that must be treated as ordinary income is the lesser of these two amounts. For example, you put a piece of machinery with a five-year class life into service in 2016. It had a cost basis of $5,000. In 2018, you sold it to another company for $3,000. Under MACRS, you would have taken the following deductions:
- 2016 $1,000
- 2017 $1,280
- 2018 $522.24
The depreciation limitation would be $2,802.24. You must also consider the gain limitation. In 2018, your adjusted basis would be $2,802.24. You sold the property for $3,000, which means you had a gain of $197.76. This lower gain limitation is the amount you must recapture, or treat as ordinary income for 2018.
Some types of property may be fully expensed in the year they were acquired. You can only fully expense up to $510,000 of property and only up to the amount of taxable business income. If you took a section 179 deduction for depreciation, you must recapture depreciation in any year during the property's recovery period where your business usage of the asset drops below 50 percent. You calculate this by subtracting the amount of depreciation that would have been allowable without the Section 179 deduction from the amount of the section 179 deduction taken.