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Thursday, May 2, 2024
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Case Studies |
Baroness Edna and the Depreciation Dilemma, Part 1
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Case:
Will Rogers has been credited with saying "Buy land. They ain't making any more of the stuff." These words were not lost on Edna Appleby. Edna began purchasing parcels of land around her southern California home many years ago. She purchased only investment properties and these properties have paid off handsomely over the years. It was not long before Edna became known in her community as "Baroness Edna."
One property Edna owns is a large office building. The building was purchased years ago for $200,000 and is now valued at $1,000,000. Edna, who has learned a thing or two about owning investment properties, has depreciated the building. The basis in Edna's building has been depreciated by $100,000 ($50,000 of which is attributable to the straight-line method of depreciation and $50,000 of which is attributable to the accelerated method).
Although the office building has been profitable for Edna, she decided to sell the office building and diversify her holdings. Edna approached her accountant and asked about the feasibility of selling the office building.
Question:
Edna asked Kate, her CPA, "How will I be taxed if I sell my investment office building? And, would I be better off considering a charitable remainder trust or a gift annuity?"
Solution:
"Now, Edna," Kate said, "You have taken some depreciation on the building. This was a good plan in order to get you a deduction on your taxes in previous years. However, because accelerated depreciation was taken on the building, there will be some recapture issues." Edna smiled at Kate and asked about the tax consequences and what impact the recapture would have. Kate explained to Edna that when a property on which accelerated depreciation has been taken is sold, the difference between accelerated depreciation and straight-line depreciation is taxed to the seller as ordinary income.
"Give it to me in real numbers, Kate," said Edna, "I understand real numbers."
"Your building has a fair market value (FMV) of $1,000,000 and an original cost basis of $200,000," Kate said. "You have taken $100,000 in depreciation and $50,000 of that was accelerated depreciation. In total, your new basis in the property is $100,000. If you sell the property today, you will have $800,000 of long-term capital gain taxed at 23.8% ($1,000,000 FMV less the $200,000 original basis). You will also have $50,000 of capital gains attributable to straight-line depreciation and this is taxable at 28.8% ($100,000 total depreciation less the $50,000 accelerated depreciation). Finally, you will have $50,000 of recapture taxed at ordinary income rates as high as 43.4% ($50,000 of accelerated depreciation is recaptured as ordinary income)." Kate sighed as she finished her explanation then handed Edna a notepad with the following chart.
Property Information
$1,000,000 - FMV
$200,000 - Original Cost Basis
$100,000 - Total Depreciation
$50,000 - Straight-Line Depreciation
Sale Information
$800,000 - Long-Term Capital Gain (23.8%)
$50,000 - Ordinary Income (Recapture) (as high as 43.4%)
$50,000 - Capital Gain Attributable to Straight-Line Depreciation (28.8%)
"I hope this explains the tax issues associated with the sale of your building," Kate said. "Unfortunately, I have another meeting and we will have to wait until next week to discuss charitable plans for this building."
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