Excess Accelerated Depreciation
Excess accelerated depreciation is a term used in real estate taxation that stands for the accumulated difference between the depreciation claimed under accelerated methods for tax purposes and what would have been claimed under straight-line depreciation. This difference often becomes significant, especially when dealing with long-term property holdings.
Prior to the 1986 Tax Act, taxpayers could use various accelerated depreciation methods like the double-declining balance method to claim higher depreciation deductions in the early years of a property’s life. This provided substantial tax benefits upfront. However, excess accelerated depreciation usually has to be recaptured as ordinary income, contrasting with the more beneficial capital gains treatment upon the sale of the property.
Key Points:
- Accelerated Depreciation: Methods that allow for higher depreciation expenses in the early years of an asset’s life.
- Straight-Line Depreciation: Method in which the cost of an asset is evenly spread out over its useful life.
- Excess Accelerated Depreciation: The difference between the accelerated and straight-line depreciation.
- Depreciation Recapture: The process of treating the previously deducted depreciation as ordinary income upon the sale of the asset.
- 1986 Tax Act: Limited the use of accelerated depreciation methods for real estate acquired thereafter, decreasing the differential benefits.
Examples
Example 1: Early Sale
Suppose a real estate investor used accelerated depreciation to claim $10,000 annually for the first five years on a $100,000 property but would have claimed $5,000 annually using straight-line depreciation. If the property is sold after five years, the excess accelerated depreciation ($5,000 ($10,000 - $5,000) × 5 years = $25,000) would potentially be recaptured as ordinary income upon the sale.
Example 2: Full Depreciation Schedule
For a $100,000 property scheduled for 27.5 years of depreciation, an accelerated method might result in $30,000 in the first decade. Straight-line depreciation might only be $20,000. On sale after ten years, the differential of $10,000 could be subject to recapture as ordinary income.
Frequently Asked Questions (FAQs)
What is the significance of the 1986 Tax Act in relation to accelerated depreciation?
The 1986 Tax Act reduced the benefits of using accelerated depreciation for real estate by requiring straight-line depreciation for properties acquired after this point. It also minimized the preferential gap between ordinary income and capital gains rates, thereby lessening the benefit of early large deductions.
How is excess accelerated depreciation recaptured upon the sale of a property?
When the property with accumulated excess accelerated depreciation is sold, this excess is recaptured as ordinary income. This means the taxpayer must include this excess in their taxable income, which can be at a higher ordinary income tax rate compared to capital gains rates.
Does excess accelerated depreciation apply to non-real estate assets?
Yes, it can apply to any asset where accelerated depreciation methods were employed. However, the specific recapture rules and impact can differ based on the type of asset and applicable tax regulations.
Related Terms
Depreciation Recapture
The process of converting previously claimed depreciation deductions back into taxable income upon the sale of the asset.
Accelerated Depreciation
Depreciation methods that allow higher expense allocation in the early years of an asset’s life.
Straight-Line Depreciation
An accounting method by which an asset’s depreciation is evenly spread across its useful life.
Ordinary Income
Income earned through standard means such as wages, interest, and regular business activities, taxed at standard federal income tax rates.
Capital Gains
Profit earned from the sale of an asset, subject to different tax rates than ordinary income.
Online Resources
- IRS Publication 946: How To Depreciate Property
- Investopedia on Depreciation Recapture
- TurboTax Guide: Depreciation Recapture
References
- Internal Revenue Code, Section 1250: Governs recapturing depreciation from real property.
- Publication 544, Sales and Other Dispositions of Assets: Detailed IRS guidelines on dealing with asset sales, including depreciation recapture.
Suggested Books for Further Studies
- “Investment Analysis for Real Estate Decisions” by Gaylon E. Greer and Phillip T. Kolbe
- Provides in-depth strategies and analysis techniques for real estate investments, including the tax implications of depreciation.
- “Real Estate Taxation” by David Windish
- Detailed coverage of the tax considerations in real estate transactions.
- “The Real Estate Investor’s Tax Strategy Guide” by Edwin Chorney and Mark Moulton
- Offers practical advice on tax planning specific to real estate investments.
