Depreciation recapture is the generation of some sort of gain that helps to offset the depreciation previously incurred on an asset. In many cases, this recapture is generated when the asset is sold for an amount that is more than the depreciation previously claimed on annual tax returns. The creation of this type of gain requires that the depreciation recaptured be reported as income to the appropriate tax agency.
One of the easiest ways to understand how depreciation recapture takes place is to consider a business that purchases some type of equipment for use in its operation. Once purchased, the equipment is used for several years, and the company claims depreciation during each of those years, based on current tax laws. Over time, the total amount of depreciation claimed comes to roughly sixty percent of the original purchase price.
After several years of use, the business is able to sell the used equipment for a figure that helps to offset the amount of depreciation claimed on the series of annual tax returns. When this is the case, it is necessary to report the depreciation recapture as income for the current period. Many national tax agencies have specific guidelines for calculating the amount of the depreciation recapture that is considered income, and often require specific forms to manage the reporting.
For example, assume the business originally paid $20,000 United States Dollars (USD) for the equipment. Over the course of the next six years, the business claims depreciation on the equipment that amounts to $12,000 USD. During the seventh year, the business sells the depreciated equipment for $12,000 USD. When the tax return for that seventh year is prepared, the business must report a depreciation recapture of $4,000 USD, which is the difference between the figure of the depreciated tax basis and the original sales price.
In many countries, the national tax agency will require the use of a specific form to report the depreciation recapture, and thus identify the source of the income. For businesses operating in the United States, this is managed with the use of what is known as Form 4797, a document that is supplied by the Internal Revenue Service. Depending on the tax laws that prevail in a given country, the income from the recapture may be reported as capital gains, or simply as ordinary income. This makes it important to understand the current tax regulations and how they apply to this reporting of recovered depreciation through the sale of assets.