Economic stimulus implications: Bonus Depreciation recapture is coming

Recently, I came across an article written by Hal Vandiver for the Material Handling Industry of America regarding the current Economic Stimulus Package and its impact on asset-owning businesses. Mr. Vandiver described the initial benefit of this measure very well, including some mathematical analysis of asset purchases that occur in 2008 or 2009. Put simply, the continuation of A one-time “bonus” depreciation allowance claimed against the starting Tax Basis of qualifying property. Eligible to be claimed in the year the eligible property is placed in service, the allowance is an additional deduction computed after any Section 179 expense (if applicable) and before any MACRS depreciation deductions are calculated. Bonus Depreciation and increased Section 179 deductions as economic stimulation have a significant impact for companies able to take advantage of these measures. That said, there is a hangover looming in the distance of which these companies should be aware. That hangover is "depreciation recapture" caused by an artificially lower basis than would normally apply to these assets. Clearly, these stimulation measures are a double-edged sword, in the form of immediate increased depreciation expense, yet an artificially lower basis (therefore higher taxes) if these assets are sold before the end of their MACRS recovery lives.

Having myself recently written an article comparing the American Recovery and Reinvestment Act of 2008 to Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange s, I thought perhaps an extension of the math used by Mr. Vandiver to include a look at the remaining basis of these assets would demonstrate depreciation recapture and connect the dots between these active economic stimulation measures and Section Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange s.

What follows is an analysis outlining the benefits of Section 179, Bonus Depreciation and Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange s for MACRS 5-year assets (Mr. Vandiver reviewed 7-year assets; however the principles are the same, and the application of 5-year recovery periods is more common for transportation assets, equipment, aircraft, information systems and many other assets). For calculation of depreciation recapture, I have assumed an 80% residual value for assets sold in year 2 of their recovery periods, and a blended income tax rate of 37%. To understand the implications for any transaction you are contemplating for your business, be sure to contact your tax advisor.

SCENARIO 1: BASELINE - STANDARD DEPRECIATION (pre and post 2008-2009 tax years)

New Machine Purchase - $100,000

Standard MACRS The gradual reduction in value of an asset over time. The IRS requires investors to depreciate real estate (and certain other assets) over a specified period of time. Residential real estate uses a 27.5 year schedule, and commercial real estate uses a 39 year schedule. Depreciation (20%) - $20,000

Asset The value of the taxpayer's investment in a property. Basis after 1^st Year (includes ½ year of 2^nd year depreciation*) - $64,000

Selling Price in 2^nd Year - $80,000

The amount received for a property, minus the property’s adjusted basis and transaction costs. Regardless of the adjusted basis of a property, there is no gain until the property is transferred. There are two types of gain: “realized gain” and “recognized gain.” Realized gain is the difference between the total consideration (cash and anything else of value) received for a piece of property and the adjusted basis. Realized gain is not taxable until it is recognized. Gain is usually, but not always, recognized in the year in which it is realized. If gain is not recognized in the year it is realized, it is said to be deferred. In an exchange under Section 1031, realized gain is recognized in part or in full to the extent that boot is received. See Boot. Where only like kind property is received, no gain is recognized at the time of the exchange. Gain on Sale - $16,000

The gradual reduction in value of an asset over time. The IRS requires investors to depreciate real estate (and certain other assets) over a specified period of time. Residential real estate uses a 27.5 year schedule, and commercial real estate uses a 39 year schedule. Depreciation Recapture (37% Income Tax on Gain) - $5,920

SCENARIO 2: BASELINE WITH BONUS DEPRECIATION (2008-2009 tax years)

New Machine Purchase - $100,000

1^st Year A one-time “bonus” depreciation allowance claimed against the starting Tax Basis of qualifying property. Eligible to be claimed in the year the eligible property is placed in service, the allowance is an additional deduction computed after any Section 179 expense (if applicable) and before any MACRS depreciation deductions are calculated. Bonus Depreciation (50%) - $50,000

PLUS Standard MACRS Depreciation on Remaining The value of the taxpayer's investment in a property. Basis (20% * $50k) - $10,000

Asset The value of the taxpayer's investment in a property. Basis after 1^st Year (includes ½ year of 2^nd year depreciation*) - $32,000

Selling Price in 2^nd Year - $80,000

The amount received for a property, minus the property’s adjusted basis and transaction costs. Regardless of the adjusted basis of a property, there is no gain until the property is transferred. There are two types of gain: “realized gain” and “recognized gain.” Realized gain is the difference between the total consideration (cash and anything else of value) received for a piece of property and the adjusted basis. Realized gain is not taxable until it is recognized. Gain is usually, but not always, recognized in the year in which it is realized. If gain is not recognized in the year it is realized, it is said to be deferred. In an exchange under Section 1031, realized gain is recognized in part or in full to the extent that boot is received. See Boot. Where only like kind property is received, no gain is recognized at the time of the exchange. Gain on Sale - $48,000

The gradual reduction in value of an asset over time. The IRS requires investors to depreciate real estate (and certain other assets) over a specified period of time. Residential real estate uses a 27.5 year schedule, and commercial real estate uses a 39 year schedule. Depreciation Recapture (37% Income Tax on Gain) - $17,760

SCENARIO 3: BASELINE WITH STANDARD SECTION 179 DEDUCTION (pre and post 2008-2009 tax years)

New Machine Purchase - $400,000

Section 179 Deduction - $128,000

Standard MACRS The gradual reduction in value of an asset over time. The IRS requires investors to depreciate real estate (and certain other assets) over a specified period of time. Residential real estate uses a 27.5 year schedule, and commercial real estate uses a 39 year schedule. Depreciation (20% * $272k) - $54,400

Asset The value of the taxpayer's investment in a property. Basis after 1^st Year (includes ½ year of 2^nd year depreciation*) - $174,080

Selling Price in 2^nd Year - $320,000

The amount received for a property, minus the property’s adjusted basis and transaction costs. Regardless of the adjusted basis of a property, there is no gain until the property is transferred. There are two types of gain: “realized gain” and “recognized gain.” Realized gain is the difference between the total consideration (cash and anything else of value) received for a piece of property and the adjusted basis. Realized gain is not taxable until it is recognized. Gain is usually, but not always, recognized in the year in which it is realized. If gain is not recognized in the year it is realized, it is said to be deferred. In an exchange under Section 1031, realized gain is recognized in part or in full to the extent that boot is received. See Boot. Where only like kind property is received, no gain is recognized at the time of the exchange. Gain on Sale - $135,920

The gradual reduction in value of an asset over time. The IRS requires investors to depreciate real estate (and certain other assets) over a specified period of time. Residential real estate uses a 27.5 year schedule, and commercial real estate uses a 39 year schedule. Depreciation Recapture (37% Income Tax on Gain) - $50,290

SCENARIO 4: BASELINE WITH BONUS AND INCREASED SECTION 179 DEDUCTION (2008-2009 tax years)

New Machine Purchase - $400,000

Section 179 Deduction - $250,000

PLUS A one-time “bonus” depreciation allowance claimed against the starting Tax Basis of qualifying property. Eligible to be claimed in the year the eligible property is placed in service, the allowance is an additional deduction computed after any Section 179 expense (if applicable) and before any MACRS depreciation deductions are calculated. Bonus Depreciation (50% * $150k) - $75,000

PLUS Standard MACRS The gradual reduction in value of an asset over time. The IRS requires investors to depreciate real estate (and certain other assets) over a specified period of time. Residential real estate uses a 27.5 year schedule, and commercial real estate uses a 39 year schedule. Depreciation (20% * $75k) - $15,000

Asset The value of the taxpayer's investment in a property. Basis after 1^st Year (includes ½ year of 2^nd year depreciation*) - $48,000

Selling Price in 2^nd Year - $320,000

The amount received for a property, minus the property’s adjusted basis and transaction costs. Regardless of the adjusted basis of a property, there is no gain until the property is transferred. There are two types of gain: “realized gain” and “recognized gain.” Realized gain is the difference between the total consideration (cash and anything else of value) received for a piece of property and the adjusted basis. Realized gain is not taxable until it is recognized. Gain is usually, but not always, recognized in the year in which it is realized. If gain is not recognized in the year it is realized, it is said to be deferred. In an exchange under Section 1031, realized gain is recognized in part or in full to the extent that boot is received. See Boot. Where only like kind property is received, no gain is recognized at the time of the exchange. Gain on Sale - $272,000

The gradual reduction in value of an asset over time. The IRS requires investors to depreciate real estate (and certain other assets) over a specified period of time. Residential real estate uses a 27.5 year schedule, and commercial real estate uses a 39 year schedule. Depreciation Recapture (37% Income Tax on Gain) - $100,640

For each of the above scenarios, the application of Section Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange treatment would defer the recognition of gain on sale; therefore the depreciation recapture problem is removed. Assets that take advantage of either of these economic stimulation measures and are sold at any point before the end of their recovery lives will face artificially lower bases, and therefore suffer from larger depreciation recovery issues in the form of higher taxes. Fortunately, these inflated tax payments can be postponed through the utilization of Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange s.

While this analysis is intended to demonstrate the depreciation recapture issue, rather than the complete benefit of Section Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange s, it is worth noting that at any point during or after an asset's MACRS recovery life, Section Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange s can have a significant bottom-line impact until such time as their market-driven residual values become insignificant.

*Assuming the Midyear Convention is utilized for determining remaining basis in these assets, and that the asset has not reached the end of its The current method of accelerated asset depreciation in the United States is known as the Modified Accelerated Cost Recovery System (MACRS). MACRS divides all assets into classes which dictate the number of years over which an asset's cost will be recovered. MACRS depreciable life, these assets will receive an additional depreciation allowance equal to ½ of the allowable depreciation for the year in which they are sold. The The current method of accelerated asset depreciation in the United States is known as the Modified Accelerated Cost Recovery System (MACRS). MACRS divides all assets into classes which dictate the number of years over which an asset's cost will be recovered. MACRS schedule allows a half year of depreciation in the first and last recovery years. Consult your tax advisor to understand the Convention required for your asset types and placed in service dates (i.e. if more than 40% of the The current method of accelerated asset depreciation in the United States is known as the Modified Accelerated Cost Recovery System (MACRS). MACRS divides all assets into classes which dictate the number of years over which an asset's cost will be recovered. MACRS property is placed in service in the last quarter, the Midquarter Convention must be used).

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Thanks to Joe Lane for pointing me to this article.