Understanding Depreciation Recapture: What Every Horseman and Jockey Should Know
Depreciation is a cornerstone of tax planning for horsemen and small business owners who own assets such as broodmares, tractors, and rental properties. While depreciation provides immediate tax benefits, it also brings long-term tax consequences when selling an asset. Specifically, depreciation recapture can impact your net proceeds and overall tax liability. This article will walk you through the concept of depreciation, its role in the tax code, and how recapture works when selling assets commonly held by horsemen and small business owners.
What is Depreciation?
Depreciation is a tax concept that allows businesses and individuals to recover the cost of a tangible asset over its useful life. The IRS recognizes that assets used in a trade or business wear out, become obsolete, or lose value over time. Depreciation allocates this loss of value across several years, reducing taxable income annually.
Why Depreciation Exists in the Tax Code
The purpose of depreciation is to encourage investment in business assets by providing tax relief for their gradual wear and tear. For example, a horseman who purchases a new trailer or upgrades farm equipment can deduct part of the cost each year, helping offset the expense. Without depreciation, the full cost of the asset would have to be recovered only at the time of sale, creating a significant financial burden.
Depreciation is Not Optional
Once an asset is placed in service for business use, depreciation is mandatory. The IRS requires you to claim depreciation, and it assumes you’ve done so whether or not you include it on your tax return. This is important because depreciation recapture applies to any allowable depreciation, even if you choose not to claim it.
Depreciation and Your Adjusted Cost Basis
The adjusted cost basis of an asset is its original purchase price, adjusted for depreciation and other factors. Depreciation reduces your basis, which in turn increases your taxable gain when you sell the asset.
Depreciation Recapture: The Basics
When you sell an asset for more than its adjusted basis, the IRS requires you to "recapture" the depreciation deductions you claimed (or could have claimed) in previous years. Depreciation recapture treats this portion of your gain as ordinary income or subjects it to specific tax rates, depending on the type of asset.
Tax Rates Applicable to Depreciation Recapture
The tax rates for depreciation recapture depend on the type of asset:
Real Property (e.g., rental property): Recapture is taxed as ordinary income with a maximum rate capped at 25%.
Personal Property (e.g., tractors, trucks, broodmares): Recapture is taxed at your ordinary income tax rate, which, for federal income taxes) can be as high as 37% (2024).
Detailed Example: Depreciation Recapture for a Broodmare
Broodmares used in a horse breeding business are typically classified as 7-year property under the Modified Accelerated Cost Recovery System (MACRS). The 200% declining balance method is used for depreciation. Depreciation tables can be found in Appendix A of IRS Publication 946. Here’s how depreciation recapture would apply in a real-world scenario for a broodmare.
Purchase:
You purchase a broodmare for $100,000 in Year 1 and place her in service for your breeding operation.
Depreciation Schedule:
Under MACRS, the broodmare is depreciated over 7 years using the 200% declining balance method. This method allows higher depreciation in the earlier years. The IRS provides standard depreciation percentages for 7-year property, as shown below:
Depreciation Claimed:
If the broodmare is used for 5 years, the total depreciation claimed is:
Year 1: $14,290
Year 2: $24,490
Year 3: $17,490
Year 4: $12,490
Year 5: $8,930
Total Depreciation Claimed (5 years): $77,690
Adjusted Basis:
The adjusted cost basis is the original cost minus the depreciation claimed:
Original Cost: $100,000
Less Depreciation Claimed: $77,690
Adjusted Basis: $22,310
Sale
At the end of year 5, you sell the broodmare for $80,000.
Taxable Gain:
Your taxable gain is the difference between the sale price and the adjusted basis:
Sale Price: $80,000
Adjusted Basis: $22,310
Taxable Gain: $57,690
Depreciation Recapture
The IRS requires you to "recapture" depreciation up to the total depreciation claimed ($77,690 or the amount of the gain, whichever is lower). This portion of the gain is taxed at ordinary income tax rates, while any additional gain is taxed at the lower capital gains rate.
Depreciation Recaptured: $57,690 (equal to the taxable gain).
Tax Rate on Recapture: Depreciation recapture for personal property (like a broodmare) is taxed at ordinary income tax rates, up to 37%.
Tax Calculation
Assume your ordinary income tax rate is 32%. Since the entire gain is due to depreciation recapture, the entire $57,690 is taxed as ordinary income.
Depreciation Recapture Tax: $57,690 x 32% = $18,460.80
Net Proceeds After Tax
Your sale proceeds after taxes are calculated as:
Sale Price: $80,000
Less Taxes Owed: $18,460.80
Net Proceeds: $61,539.20
Modified Example: Depreciation Recapture for a Broodmare Sold Above the Original Purchase Price
Let’s consider a scenario where a broodmare is sold for more than the original purchase price, $120,000 in this case, highlighting the impact of both depreciation recapture and capital gains tax. This situation demonstrates how gains are taxed differently based on depreciation and appreciation.
Taxable Gain:
Your total taxable gain is calculated as:
Sale Price: $120,000
Adjusted Basis: $22,310
Taxable Gain: $97,690
Depreciation Recapture and Capital Gain
The IRS separates the taxable gain into two parts:
Depreciation Recapture: The portion of the gain attributable to depreciation is recaptured and taxed at your ordinary income tax rate.
Capital Gain: Any gain exceeding the original purchase price ($20,000 in this case) is taxed at long-term capital gains rates if the property was held for more than one full year. Note: Broodmares must be held for 2 years to qualify as a long-term capital gain.
Tax Breakdown:
Depreciation Recaptured: $77,690 (the total depreciation claimed, limited to the gain attributable to depreciation).
Capital Gain: $120,000 - $100,000 = $20,000 (the amount above the original purchase price).
Tax Calculation
Assumptions:
Ordinary Income Tax Rate: 32% (applied to depreciation recapture).
Long-Term Capital Gains Rate: 15% (applied to the portion above the original purchase price).
Depreciation Recapture Tax:
$77,690 x 32% = $24,860.80
Capital Gains Tax:
$20,000 x 15% = $3,000
Total Taxes Owed:
Depreciation Recapture Tax: $24,860.80
Capital Gains Tax: $3,000
Total Tax Liability: $27,860.80
Net Proceeds After Tax
Your sale proceeds after taxes are calculated as:
Sale Price: $120,000
Less Taxes Owed: $27,860.80
Net Proceeds: $92,139.20
Note: The two scenarios presented here are for illustrative purposes and should not be used as a basis for actual calculations of depreciation. They ignore specific changes to deprecation calculations in the year of purchase or sale such as the Half-year or Mid-quarter conventions. Additionally, certain property may be eligible for Bonus or Section 179 depreciation, which are outside the scope of this article. Finally, they account for Federal Taxes only and exclude state and local income taxes.
Types of Depreciation Recapture That May Surprise People
Now that we’ve reviewed depreciation recapture in two similar scenarios, here is a short list of types of depreciation recapture that often surprise people.
Home Office Depreciation:
Even if you sell your primary residence and qualify for the capital gains exclusion, depreciation claimed for a home office must be recaptured and taxed as ordinary income.Equipment Sold for Less than Purchase Price:
Even if you sell equipment like a tractor or truck for less than its original cost, you may still owe recapture tax on depreciation claimed if the sale price exceeds the adjusted basis.Rental Property:
Depreciation recapture on rental properties is recaptured at a federal tax rate of up to 25%, even if the property is sold at a loss overall compared to its original purchase price.Partially Business-Used Assets:
Depreciation claimed on assets used partially for personal purposes (e.g., a car or horse trailer) must be recaptured for the business-use portion upon sale.Assets Given as Gifts:
If you gift a depreciated asset, the recipient inherits both the basis and the depreciation history, potentially triggering recapture when they sell the asset.Early Sale of Assets:
Selling an asset before the end of its useful life doesn’t eliminate recapture liability; you still owe tax on depreciation claimed up to the sale date.
Final Thoughts
Depreciation is a valuable tool for horsemen and small business owners to reduce taxable income and allow them to reduce cash lost to taxes when reinvesting in their business, but it comes with long-term implications. Depreciation recapture can significantly impact your tax liability when you sell an asset and often catches people by surprise. By understanding the rules and planning ahead, you can maximize the benefits of depreciation while minimizing surprises at tax time. Always consult with a tax professional to navigate these complex rules and create a strategy tailored to your situation.
If you need help understanding the impacts of depreciation recapture on your business, contact me at Derek@trophypointfp.com
Additional Sources:
IRS Publication 946: How to Depreciate Property
IRS Publication 544: Sales and Other Dispositions of Assets
Dean Dorton: Federal Equine Depreciation Summary
