Understanding Depreciating Assets

[SteveKoz]

December of 2021 I purchased a furnace for a rental property.  $10,900.  I decided to depreciate it over 5 years since we were thinking about selling and wanted to offset the sale gains. Classified type of asset as F-Rental furnishings. Received $545 depreciation for 2021 taxes.  We sold the property in May 2022.  I was expecting close to $10K in the final depreciation for this asset but turbo tax only calculated $4,142.  Is this a bug in Turbo Tax or am I not understanding depreciation correctly?  Thanks

[SteveKoz]

When you are depreciating assets and you sell the property do you get all the undepreciated value left as a write off or just the current years portion up to the sale and the rest is lost?   Just trying to get my head around this.  Thanks!

[Hal_Al]

Basically, the answer is: "it doesn't work that way".

Your cost basis when you sell the asset (furnace) is $10, 900. Then you enter the depreciation previously claimed ($545), which is treated as a section 1250 capital gain ("depreciation recapture"). So, yes you effectively write off $10,355 (10,900 - 545). But you deduct it as cost basis, not depreciation. 

[Carl]

When you are depreciating assets and you sell the property do you get all the undepreciated value left as a write off or just the current years portion up to the sale and the rest is lost?

Neither. Many have the incorrect belief that depreciation is a permanent deduction. It is not. When you sell the property/asset, you are required to recapture all depreciation taken in the year of the sale, and pay taxes on it. If one thinks they can get around that by not depreciating the property/asset, that's not so. The law reads that you are required to recapture the depreciation taken, or the depreciation you *should* have taken, in the year the sell the property/asset.  Two things about depreciation recapture.

1) Recaptured depreciation is added to your AGI in the tax year you sell. This has the potential to bump you into the next higher tax bracket. It just depends on the numbers.

2) Recaptured depreciation is taxed at the ordinary tax rate anywhere from 0% to a maximum of 25%. Again, it just depends on the numbers.

[SteveKoz]

Still confused.  When I purchased the furnaces I could have taken the entire cost as an expense in the year purchased OR I could depreciate it.. right?  As an expense it's deducted from my income in that year and done  where what you are saying is that by depreciating it I get to take a bit every year until fully depreciated BUT at some point I have to claim the depreciation when I sell?   Sorry I'm not understanding..  Appreciate the help!

[Hal_Al]

Q. When I purchased the furnaces I could have taken the entire cost as an expense in the year purchased...right?

A. No. The option to "expense" an improvement is very limited and a $10K furnace would not have qualified. 

Depreciation is a deduction of your cost basis, over the years.  When you finally sell the asset, you get to deduct your cost basis from the sale price. Depreciation recapture  keeps you from double dipping (deducting it twice; over the years and at sale time)

[Carl]

Still confused. When I purchased the furnaces I could have taken the entire cost as an expense in the year purchased OR I could depreciate it.. right?

Unfortunately, no. Your understanding is wrong.  In order to deduct the cost of an asset as an expense under the Safe Harbor di-Minimus act, the first requirement is that it's cost must be less than $2,500. Earlier you stated the new furnace cost $10,900. So expensing it was not an option. Therefore, the other requirements to qualify for the safe harbor deduction are a moot point.

You also incorrectly classified it under MACRS as an appliance. A new furnace becomes "a physical and permanent part of" the structure. Just like the plumbing is a physical and permanent part of" the structure. It should have been classified under MACRS as Residential Rental Real Estate and depreciated over 27.5 years, same as the structure. Since you sold the property, going back to change that now is a waste of time and will not help you on the tax front. More than likely, it would hurt more than help.

When you sell the property, you are required to recapture the *higher* of depreciation taken, or the depreciation you should have taken, and pay taxes on that recaptured depreciation in the year you sell. Since what you actually claimed for depreciation is higher, that's what you have to recapture. So just leave the current setup alone since you sold it.

at some point I have to claim the depreciation when I sell?

Contrary to what you may have been told in the past, depreciation is not, and never has been a permanent deduction. When you sell business property (and rental property is a type of business property) you are required to recapture all depreciation taken, or the depreciation you should have taken (whichever is higher) and pay taxes on it in the year of the sale.

Recaptured depreciation is taxed as "ordinary income" anywhere from 0% to a maximum of 25%. What your tax rate on the recaptured depreciation is, depends on the numbers (AGI and the such).  Whereas your gain on the sale of the property is taxed at the capital gains tax rate.

Two things about recaptured depreciation:
1) Recaptured depreciation is added to your AGI. So there's the potential it could bump you into the next higher tax bracket.

2) Recaptured depreciation is taxed at the ordinary tax rate, anywhere from 0% to a maximum of 25%.  So if the income from the sale combined with the recaptured depreciation puts you in a tax bracket above 25%, then it helps. Otherwise, it makes no real difference. But still, the SEC 1250 gain on the sale will be taxed at the capital gains tax rate. For some, that rate is higher than the ordinary tax rate. For others it's lower. It just depends on the numbers.

Sorry I'm not understanding.. Appreciate the help!

No apologies necessary, as it's not like you learn this stuff through osmosis. I certainly didn't. 🙂

[papa281]

Can you answer this question:  What is the difference between Prior Depreciation and Prior Year Depreciation?

Thank You

[CatinaT1]

Prior Depreciation is the total amount of all depreciation for all years prior, while Prior Year Depreciation refers only to the one year before.

Does this answer your question? Reply if you still have further questions. 

[Carl]

What is the difference between Prior Depreciation and Prior Year Depreciation?

Generally in the context of the program, the spelling. 🙂

In the context of the program the "prior depreciation" is the total of all depreciation taken on an asset, since the last date that asset was placed in service.  "Prior Year Depreciation" is the amount of depreciation taken in/for the prior tax year.  Do note that the two are used interchangeably, and regardless of which is used it's fairly safe to assume "the total of all depreciation taken since the asset was last placed in service". Otherwise, if someone want's the depreciation taken last year or in any other specific year, they will specify the year.

[papa281]

In the program, when you dispose of an asset it asks for the date of disposal and then it asks for the States prior year depreciation.  If the prior years depreciation was “0” would you enter that or if the total depreciation let’s say $2,000 would you enter that?

Thank you

[DavidD66]

@papa281 You have an Asset Detail report from the prior year tax return that shows the amount of accumulated depreciation (Federal, AMT, and State).  The amount of State prior years depreciation will be on that report.  The amount should not be $0.  It could be as much as the cost (the amount you capitalized).  Whatever that amount, is what you enter.

[papa281]

On the asset depreciation report it does not show the State depreciation.  The far left column is the name of the asset and the cost. The other columns on the right shows the total amount of depreciation and the last column is “This year’s depreciation “.  If the asset is fully depreciated then the last Column is “0”.  So when you dispose of an asset and the program asks about what was the prior year depreciation and the prior year in the last column is “0” but the total prior depreciation was $2,000.  Which amount is the correct amount to enter?

[KrisD15]

2,000

the program is asking how much deprecation TOTAL had been taken on that asset as of last year. 

When you sell a business or rental item that has been depreciated, there are two types of income that can be generated from the sale:

Capital Gain (the amount you sell it for that is over the price you paid) 

Depreciation Recapture (the amount of depreciation you "took" ((or could have taken)) that you now need to "give back"

Since you had a 2,000 asset that was completely depreciated, any proceeds you get if you sell it would be Ordinary Income. 

If the asset was disposed of, there would be no value left to claim as an expense and no depreciation to recapture. 

[papa281]

Thanks