Tax question- depreciation

The question- do you have to depreciate business property?

I bought an office building in 2002. Knew I would only be in it 10 or 12 years (until retirement age). I depreciated it on a 33 year basis per IRS instructions. I was only in the 15% bracket for most of those years, so depreciation didn't help much. But when I sold, between recapture of depreciation and gain on the sale, it flipped me into the 25% bracket, all in one year, and cost me a bundle. In retrospect, knowing that I would sell it for more than I paid, I'd have been better off not even bothering with depreciation. Can you just ignore depreciation?

You do not have to take all your deductions. IT is entirely up to you if you take them or not. I do not depreciate my brood cows even though I could. It makes the record keeping more evolved if you deduct them. Also the gain is taxed as earned income if they are deducted, where if they are not deducted then the gain is capital gains and taxed at that rate which is usually lower than your earned income tax rate.

Mike, in general, when you calculate gain/loss the wording is, to paraphrase, depreciation that was or could have been taken. I cannot, without doing a lot of research that I have not the time to do right now, tell you if the law says that you have to actually record the expense. It does, however, state that when you go thru disposition that you must take into account any depreciation that was available to take without regard to whether you took the expense. I have seen people not take depreciation on a tax return. Do not see a problem with it as long as they understand the long term ramifications.

Glance at line two of Form 4797, column e header.

HTH,

Dave H (MI) CPA

I agree with you, JD, but what bothers me is what Dave brought up- Form 4797 says "Depreciation allowed or allowable"- so I think you're stuck, if you characterize it as "business property". You could call it "investment property", but then I don't think you get capital gains on the gain. What gripes me is that "depreciation" is supposed to reflect the decrease in value of business property as it wears out. That works with machinery, but I bought the real estate in a short sale, for less than its FMV at the time, and I knew I'd make money on it when I sold 10 or 15 years later. So why depreciate it? Its almost like an IRS trick to dribble out the deprecation tax break a little at a time, then sock you with recapturing the whole thing when you sell, and bumping you into a higher bracket. Grrrrrr. . .

With cows, I think you can just ignore the depreciation altogether, and just account for them on Schedule F (sale of purchased livestock). But you won't get capital gains treatment on them that way. But I think it would be rare to buy a brood cow, depreciate her out over 5 years, and have much of a recapture, much less a capital gain.

Actually Mike, the purpose of depreciation is to match expense with revenue and not to reflect wear and tear on equipment or it's decrease in value. The whole concept was to prevent the deduction of an item in year one because it would distort net income dramatically in that year and, to a lesser extent, every year of the life of the asset. It also would understate the Balance Sheet assets. Now, that is Financial Accounting. If you were to account for things on a tax basis then we all know that IRC Sect 179, as amended numerous times, will allow you to do just the opposite. There is also the matter of bonus depreciation. The other issue is whether or not you could reclass an item as an investment to avoid depreciation. You can do this but would it be correct...no. There are items which legitimately fall into this category, though. I had a client who owned (to keep the privacy laws happy) I will say "a couple of unrelated businesses". He was a rich guy and liked to collect old trains. Not toy trains, but real trains. He bought these thru his legitimate businesses but we classified them as "other investments" so they did not affect income. As an investment, it would be a capital asset and any gains would be capital gains. A depreciable asset such as I believe we are talking about here is only subject to capital gain rules to the extent the gain exceeds depreciation taken. It is ordinary income up to that point. Not going to make the IRS happy if you start reclassing the assets I would think. Hope this makes sense, I typed it awfully fast.

I understand about not distorting expenses vs. income. And then came all the huge §179 deducts, but I think that was more to stimulate investment.

Just for the fun of it, I'm going to look at my past returns (for tax bracket), and see how much I saved each year in taxes by depreciating- and then how much it cost me to recapture it all in one year, in a higher tax bracket. Then run it as investment property and see how it would come out that way. I'll post how it comes out.

I've wondered the same thing, Mike. I have rental properties for which the depreciation deduction is small, and I might want to sell them soon.

Everything I've read says to use "depreciation taken or allowed" when figuring cost basis. But has the IRS ever actually come back and billed somebody who didn't take depreciation and would have had additional capital gains if they had taken depreciation? It may be the law but it doesn't make sense. I assume the wording "or allowed" is specifically intended to thwart a specific tax dodge, but I have no idea what it might be.