Depreciation Recapture Financial Model for Accountants

 I was working on depreciation recapture in a financial model and it is quite complicated to build correctly with formulas. There are lots of moving pieces and things to take into account so that you have the correct taxable income (what is recaptured vs. capital gain/loss). They can offset each other so let's get into it.

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depreciation recapture

Depreciation recapture is a tax provision that requires a taxpayer to pay taxes on gains that are generated by the sale of an asset that has been depreciated for tax purposes. When an asset is purchased and used for business or income-producing purposes, the taxpayer can take a deduction for the cost of the asset over its useful life. This deduction is called depreciation and reduces the taxpayer's taxable income each year.

However, when the asset is sold, any gains from the sale are subject to taxation, including gains resulting from the deduction for depreciation. This is where depreciation recapture comes into play. Depreciation recapture is the process of recapturing or recovering the tax benefits that were received as a result of the depreciation deduction, and it requires the taxpayer to pay taxes on a portion of the gains from the sale of the asset.

There are two types of assets that are subject to depreciation recapture: Section 1245 property and Section 1250 property.

Section 1245 property includes tangible personal property, such as equipment, machinery, and furniture, and certain types of intangible property, such as patents and copyrights. When Section 1245 property is sold, any gain on the sale that is attributable to the depreciation taken on the property is taxed at ordinary income tax rates, which can be higher than the capital gains tax rate. This means that the taxpayer may owe more in taxes than they would if the gain were taxed at the capital gains rate.

Section 1250 property includes real property, such as buildings and structures. When Section 1250 property is sold, any gain on the sale that is attributable to the depreciation taken on the property is taxed at a maximum rate of 25%, which is generally lower than the ordinary income tax rate. However, if the taxpayer has taken certain types of accelerated depreciation deductions, such as bonus depreciation or Section 179 expense deduction, the portion of the gain attributable to those deductions may be subject to a higher tax rate.

To calculate depreciation recapture, the taxpayer must determine the adjusted basis of the property, which is the original cost of the asset minus any depreciation deductions taken. The gain on the sale of the property is then calculated by subtracting the adjusted basis from the sale price. The portion of the gain that is subject to depreciation recapture is calculated based on the amount of depreciation that was taken on the property.

It's important to note that depreciation recapture only applies to gains that are subject to taxation. If the sale of the asset results in a loss, the taxpayer may be able to deduct the loss from their taxable income.

In summary, depreciation recapture is a tax provision that requires taxpayers to pay taxes on gains that are generated by the sale of an asset that has been depreciated for tax purposes. The tax treatment of depreciation recapture depends on the type of property being sold and the type of depreciation deductions that have been taken. Taxpayers should consult with a tax professional to determine the tax implications of depreciation recapture on their specific situation.

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