Depreciation recapture in a small business acquisition

Appreciation is an increase in value of an asset over time. Appreciation is plausible with most assets on a balance sheet; however, depreciation of assets is much more likely. For example, fixed assets, equipment, buildings, etc. are expected to depreciate in value over time. 

Therefore, from a financial perspective, businesses are allowed to depreciate assets on a straight-line or accelerated (MACRS) basis based on the useful life of an asset. Depreciation helps offset taxes, which directly benefits a business's bottom line.

This leads to an important question, what happens to depreciation when a business is bought or sold? Can buyers depreciate the assets again? This is where depreciation recapture comes into play. This blog post looks to detail what depreciation recapture is, how to calculate depreciation recapture and costs associated with depreciation recapture.

What is Depreciation Recapture?

Typically, if you sell something you own, you will be taxed at a favorable capital gains rate (e.g., 15%). However, if you sell something that you have depreciated to offset your taxes over the year, then you may owe depreciation recapture to the IRS.

Depreciation recapture is the gain realized by the sale of depreciable assets that must be reported as ordinary income for tax purposes. The rationale for this is that the taxpayer has been able to benefit from lower taxes due to claiming depreciation. If that taxpayer then sells a piece of equipment, for example, and sees a profit above its cost basis, then the IRS should be able to recoup the lost tax revenue from years prior.

Below are common assets in a small business (SMB) that may have depreciation recapture.

• Buildings (e.g., industrial real estate, office buildings, commercial property, etc.)

• Vehicles (e.g., bucket trucks, vans, etc.)

• Equipment (e.g., robots, drills, lifts, etc.)

• Land Improvements

Now that there is a general understanding of depreciation recapture, below is a detailed example that depicts a simplified calculation of depreciation recapture.

Above is a detailed analysis of a business purchasing five trucks and then selling them at the end of year 5 for a corresponding sale price. Trucks 4 and 5 were disposed of (unable to sell); therefore, depreciation recapture is zero. For the depreciation recapture calculation, the seller must calculate an adjusted cost basis for that asset and in the above example it is the purchase price minus accumulated depreciation. This adjusted cost basis is then subtracted from the sale price to get depreciation recapture.

Note, that while not depicted above, depreciation recapture is the smallest amount between accumulated depreciation for that asset and the difference between sale price and adjusted cost basis.

Depreciation recapture can have some complexity to it; therefore, it is recommended to discuss depreciation recapture with certified attorneys or accountants. That way the business isn’t hit with an unexpected tax bill.

It is important to note that a loss on the sale of an asset does NOT have depreciation recapture.

Who pays for Depreciation Recapture in an SMB acquisition?

Depreciation recapture is paid for by the seller in an SMB acquisition. This is one of the main reasons that sellers prefer stock sales to asset sales because sellers get taxed at the long-term capital gains tax rate and avoid depreciation recapture. 

However, buyers prefer asset sales because they don’t have to worry about hidden liabilities with the seller. Plus, the buyer receives a “step-up” basis on the assets it purchases and is thus able to depreciate those assets from a higher asset value than under a stock sale. The “step-up” basis is created because the seller has to pay taxes on the depreciation that is recaptured.

Clearly there is a conflict between what the buyer and seller want; therefore, in a SMB acquisition, sellers are going to require a higher purchase price (higher premium) for their business in an asset sale compared to a stock sale. The higher premium is meant to offset the taxes paid for depreciation recapture.

When is Depreciation Recapture Tax Due?

Now a common concern among entrepreneurs selling their company is when is depreciation recapture tax due? Depreciation recapture tax is assessed at the time of the sale; however, it is due during tax season for the given year the sale was made. As always, it is highly recommended that an entrepreneur reach out to their attorney or tax accountant for specifics.

Difference between Section 1245 and Section 1250 of the IRS Code

Now that there is a solid understanding of what depreciation recapture is and how to calculate it, let's turn to the rules that govern depreciation recapture. Depreciation recapture is covered under Section 1231 of the IRS code. Furthermore, Section 1231 acts as an umbrella to Sections 1245 and 1250. Section 1245 is used for most business assets. For example, depreciation recapture calculated for trucks and other equipment would fall under Section 1245. 

However, if the business being sold is a real estate firm or a business with quite a bit of real estate property, then depreciation recapture is calculated based on the rules and regulations stipulated in Section 1250. Section 1250 has added benefits for the seller of real estate property in that the tax rate applied to depreciation recapture is capped at 25 percent.

How to avoid incurring depreciation recapture?

There are a few ways to avoid incurring depreciation recapture. One way is by not allocating depreciation in excess of book value, especially when not 100 percent confident. In other words, an entrepreneur would want the sale price of the asset to equal the adjusted cost basis (depreciation recapture is zero in this scenario) that is reported to the IRS.

A few other methods to reducing tax burdens for the seller of an SMB are listed below:

• Seller financing

• Equity roll

• 1031 exchange

Each of the listed methods above will mitigate taxes in other ways. Real estate property that is sold for the intended purposes of buying real estate property that has equal or greater value and is used for investment purposes can qualify for the 1031 exchange. The 1031 exchange allows for deferment of depreciation recapture and capital gains taxes on real estate property that is sold. Thus, the 1031 exchange is an excellent way to mitigate taxes.

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.