SOURCE: Marks Paneth & Shron LLP

Marks Paneth & Shron LLP

July 29, 2013 11:09 ET

Business Owners and Partners Risk a Costly Mistake: They Forget That the IRS Can Take Their Depreciation Allowance Back -- at the Highest Tax Rate, Warns Marks Paneth & Shron

NEW YORK, NY--(Marketwired - Jul 29, 2013) - Business owners, partners and other high-net-worth individuals are at risk: They're getting depreciation wrong. They forget that when they sell an asset, the IRS can take their depreciation allowance back -- often at the highest possible tax rate.

Millions of taxpayers use depreciation to write down the cost of assets -- both tangible assets like capital equipment and real property, and intangible assets such as patent costs and goodwill. But if those assets are sold at a profit, the IRS can recapture the full amount that was depreciated.

"Contrary to what many taxpayers assume -- the agency doesn't apply the preferential capital gains tax rate to depreciated assets sold at a profit," says Peter Blumkin, senior manager in the Tax Department at New York accounting firm Marks Paneth & Shron. "Instead, in many cases the IRS recaptures depreciation at the ordinary income tax rate (which can reach as high as 39.6 percent in the highest bracket). The lower capital gains rates kick in only after the IRS gets all of its depreciation back."

"That can mean a much higher than expected tax bill on the sale of the asset. Taxpayers need to realize that there's a downside to depreciation -- it can be more costly than expected in the event of a sale," he adds.

In recent years, business owners, partners and other high net-worth individuals have been aggressive in claiming depreciation, often using preferential first-year "bonus depreciation" rates that have ranged from 30 percent to 50 percent, and for a time hit 100 percent.

But when those taxpayers sell the asset, they often find that depreciation comes back to bite them. For instance:

  • They look at depreciation only as a tax-saving strategy. They forget that tax liability beyond capital gains will apply in the event of a sale.
  • In fact, the IRS is entitled to "depreciation recapture." That means that, if an asset was subject to depreciation and amortization, and is held more than a year, the IRS first gets to recapture the depreciated amount. Only after that does the capital gains rate apply. The recapture rate is always higher -- it's capped at 25 percent for real property but is otherwise taxed at ordinary income tax rates that reach as high as 39.6 percent, as the asset may have been written off at a lower rate.
  • Business owners and partners are at risk even if there's no cash sale. If an asset is disposed of on an installment basis, or if it's transferred, depreciation recapture is fully taxable in the year of the sale, even if no cash changed hands. This can mean high tax bills for the sale or transfer of a partnership interest -- with no immediate income to offset the tax liability.

However, taxpayers can lessen the deprecation recapture bite through careful planning by:

  • Planning the sale in order to recognize ordinary income when in a lower tax bracket, or when there is a net operating loss carryover.
  • Making a bona fide gift of depreciable property. In that case, any depreciation recapture will come from the done. In some cases, a lower tax bracket may apply.
  • Postponing depreciation recapture by making a like-kind exchange. In that case, the recapture is not triggered on the exchange. Instead, it's carried over to the replacement property.

With the Bush-era tax breaks in place at least through the end of 2013, taxpayers need to remember that while bonus depreciation on leasehold improvements will almost always be beneficial, using the same approach on personal property will only defer the recapture.

"Business owners, partners and high net-worth individuals need to plan carefully, with the help of a tax professional, to make sure they are taking the best advantage of depreciation and are not at risk for higher tax liability down the road," Mr. Blumkin says.

For a bylined article or an interview with Peter Blumkin, please contact Katarina Wenk-Bodenmiller of Sommerfield Communications at (212) 255-8386 or katarina@sommerfield.com

About Marks Paneth & Shron LLP

Marks Paneth & Shron LLP is an accounting firm with over 500 people, of whom nearly 65 are partners and principals. The firm provides public and private businesses with a full range of auditing, accounting, tax, consulting, bankruptcy and restructuring services as well as litigation and corporate financial advisory services to domestic and international clients. The firm also specializes in providing tax advisory and consulting for high-net-worth individuals and their families, as well as a wide range of services for international, real estate, media, entertainment, nonprofit, professional and financial services, and energy clients. The firm has a strong track record supporting emerging growth companies, entrepreneurs, business owners and investors as they navigate the business life cycle.

The firm's subsidiary, Tailored Technologies, LLC, provides information technology consulting services. In addition, its membership in Morison International, a leading international association for independent business advisers, financial consulting and accounting firms, facilitates service delivery to clients throughout the United States and around the world. Marks Paneth & Shron LLP, whose origins date back to 1907, is the 32nd largest accounting firm in the nation and the 16th largest in the New York area. In addition, readers of the New York Law Journal rank MP&S as one of the area's top forensic accounting firms for the third year in a row.

Its headquarters are in Manhattan. Additional offices are in Westchester, Long Island and the Cayman Islands. For more information, please visit www.markspaneth.com.

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