Capital Gains and Recaptured Depreciation

1031 Exchange Capital Gain TaxProperty owners can defer the federal and state capital gain and recaptured depreciation tax using a 1031 tax deferred exchange. 

Capital gains is the net gain earned after depreciation and selling expenses given the capital asset is sold at a higher price than the original purchase price. This is one of many important data points for an investment property owner to understand along with what is a capital asset, depreciation and 1031 exchange.

Capital Asset

Capital assets are the building blocks of capitalization rates, amortization, depreciation, capital gains and 1031 exchanges. A capital asset is any real, tangible and intangible personal property held as an investment or for use in business or trade. Excluded is inventory or property held primarily for personal use and consumption. Tangible capital assets provide an offset to income in the form of depreciation given a useful life of one year or more, can wear out, decay or become obsolete due to natural causes. Examples of depreciable capital assets include  self storage facilities, apartments, commercial buildings, aircraft, office furniture, livestock, heavy and light industrial equipment, and medical equipment. Intellectual property, patent rights, and trademarks are examples of intangible personal property.

Recaptured Depreciation

Tangible capital assets are depreciated over their useful lives. Depreciation is the continuous and immutable decline in the value of the capital asset. The decline can offset or lower net income. Land cannot be depreciated. If there is a structure or the land is improved, those capital improvements can be depreciated over time. Banquet room dividers in hotels have an established useful life. Aircraft, dairy and breeding cattle are depreciated on 5-year schedules.

For tangible property, the capitalized cost (basis) is recovered over a standard life by annual deductions for depreciation. The tax depreciation system in the U.S. is the Modified Accelerated Cost Recovery System (MACRS). When the capital asset is sold, the Internal Revenue Service imposes recaptured depreciation to tax the gain because a deduction from ordinary income over the useful life of the capital asset was received.

Capital Gain Tax

Capital assets purchased are ultimately sold, potentially triggering a capital gain tax. In the case of energy companies, some capital assets are sold as scrap. When sold a fairly easy calculation determines whether a gain or loss is the outcome. Federal and possibly state and county taxes are assessed. To determine the recognized gain or capital gain tax, the following steps are completed:

  • Original purchase price plus improvements less depreciation equaling the adjusted basis.

  • Sales price less adjusted basis less selling expenses equals the realized gain.

  • The recaptured depreciation is 25 percent (for real property and at the ordinary income tax rate for personal property) of the depreciation used to determine adjusted basis.

  • Federal capital gain tax is applied to the realized gain less depreciation used to determine adjusted basis.

  • State and county taxes may be applied. Nine states including Florida, Texas, Nevada, Washington, Alaska, Wyoming, South Dakota, Tennessee, New Hampshire do not have state income tax as of early 2011.

  • Capital gain tax rates for real property held greater than one year and a day are 15-percent through 2012 given the Taxpayer is in the 25-percent tax bracket or higher. The capital gain rate may be zero for the 10-percent and 15-percent bracket. If held less than one year, ordinary income tax rates apply.

  • Federal capital gains tax rates changed January 1, 2013 with the following rates

    2013 Federal Capital Gains Tax Rates

  • For a C Corp, there are no special rates and capital gains is included in income applied to the graduated rates.

  • For a S Corp, the capital gains is passed to shareholders pro rata to be taxed on their federal 1040 return as income.

To confirm capital gain taxes seek the guidance of your CPA.

1031 Exchange

Following 1031 exchange rules, the federal and state capital gain and recaptured depreciation tax can be deferred. The value of a 1031 exchange is those taxable dollars (though eventually due when the replacement property is sold or elect not to initiate another 1031 exchange) represent an indefinite interest free loan or additional operating capital to acquire replacement property without an interest expense. A 1031 tax exchange is not tax free, though with prudent estate planning, a capital asset can be given to a beneficiary and if sold soon after receipt receives a stepped up basis and no capital gain. Seek the counsel of an estate attorney and CPA for guidance and application to the pending transaction.

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