Business Property

by Bill Sweet

Found a really cool flowchart I thought I'd pass on concerning business property from a CPA exam website (here). The key update with the 2013 tax changes is that the 5% capital gains rate no longer applies - capital gains are actually zero in the 10% or 15% tax brackets.

One of the more important concepts concerning depreciation is that it isn't a "free" tax deduction - it accumulates over time. And if you sell your business property for more than your basis (that's the original cost of your property less accumulated depreciation over the years), the difference gets recaptured and you could pay income tax on that figure.

That situation typically doesn't occur with an asset that you dispose of (sell it for $0), or an asset value that rapidly declines. It does occur a lot with real property (buildings), which typically don't decline in value over time, but actually increase at the rate of inflation.

For an example, let's say you purchase a rental property for $100,000, hypothetically depreciate the property over five years at $10,000 per year ($50,000 total), and then sell it for $150,000. On first glance it looks like you have a gain of $50,000, but you actually have a gain of $100,000 - the $50,000 capital gain PLUS $50,000 of recaptured depreciation. Because you accelerated this write-off during the five years of ownership, you're required to account for this on sale.

The tax rate you pay on that $100,000 gain is complicated and depends on your overall tax rate. In a very simple example, the $50,000 capital gain is taxable at ordinary income or maximum capital gains rate of 15% or 20% (depending on your AGI). The recapture is subject to ordinary income tax with a maximum cap of 25%.

What is neat about sales of business property is that they qualify for two types of favorable tax treatments: 1231 assets sold at a loss can be applied against gross income (unlike capital assets, such as stocks and bonds, which are subject to a $3,000 maximum write-off per year). 1231 assets sold at a gain qualify for favorable capital gains treatment at 15% or 20% once depreciation recapture is calculated and accounted for. The Journal of Accountancy has a great article on this very topic here.

If this hurts your head, don't feel bad. I find this flow chart extremely useful because it is difficult at times for me to keep it all stored! The US tax code is ridiculously complicated.

This is why it is always a good idea to take the time to look things up. And why, if you run a business, you should probably consider paying an accountant to not only help you prepare your tax return, but to also give you good tax advice going forward. Decisions you make when you purchase property can have a serious impact on your tax situation in the future.

-  Bill