What They Never Tell You About Depreciation

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In the latest episode of "Keep What You Earn," Shannon Weinstein, a seasoned CPA and business owner, delved into the often misunderstood world of depreciation and its less-talked-about companion, depreciation recapture. If entrepreneurial finance feels like eating your vegetables, think of Shannon's insights as the ranch dressing that makes the process more palatable. Today, we're unpacking the real implications of depreciation strategies and how they can affect your financial planning.

#### Depreciation: The Basics

Depreciation is a term that gets tossed around frequently in the financial sphere, especially among business owners looking to maximize their tax deductions. In essence, depreciation allows you to spread the cost of a significant asset, like a vehicle or machinery, over its useful life. It's a way of accounting for the wear and tear that these assets undergo over time, and it helps lower your taxable income in the process.

Shannon pointed out popular concepts like bonus depreciation and Section 179, which enable businesses to accelerate depreciation, taking a substantial portion of the asset's cost as a deduction in the first year. While these strategies can offer immediate tax relief, they come with a caveat: they're often deferring—not eliminating—your tax liability.

#### The Catch: Depreciation Recapture

One crucial concept Shannon introduced is depreciation recapture. This often-overlooked aspect can surprise entrepreneurs who aren't fully informed. Essentially, depreciation recapture is the IRS's way of reclaiming the tax benefits you've received from depreciation when you sell an asset.

When you sell an asset, the IRS requires you to "recapture" the depreciation deductions you've enjoyed over the years. This means you may have to pay taxes on those deductions. The tricky part comes when you compare the sale price of the asset to its book value, which is the original purchase price minus the accumulated depreciation.

#### A Real-World Example

Shannon used a practical example to illustrate this. Imagine purchasing a vehicle for your business at $20,000 and taking $18,000 in depreciation within the first year. Your book value for this vehicle now stands at $2,000. If you later sell the vehicle for $15,000, the IRS will view this as a gain of $13,000 because your book value is significantly lower than the sale price. This gain is subject to taxes due to depreciation recapture.

#### The Market vs. Book Value

A critical distinction Shannon highlighted is the difference between market value and book value. While market value is what the asset is worth based on current market conditions, book value is simply the purchase price minus accumulated depreciation. These values can differ significantly, and misunderstanding this difference can lead to unpleasant surprises when you sell an asset.

#### Selling Your Business? Things to Consider

Depreciation recapture becomes especially significant when you're selling your entire business. Business sales can be structured as either stock sales, where you sell your shares, or asset sales, where you sell individual assets. The choice of structure can have major tax implications. When you opt for an asset sale, you may have to recapture depreciation on several items, including vehicles, equipment, and machinery. This can result in a substantial tax burden, especially if these assets have been heavily depreciated.

Shannon's advice? Always consult with your tax advisor when planning to sell significant assets or your business. They can help you understand the potential tax impact and guide you in structuring the deal to minimize your tax liability.

#### Planning Ahead

Before taking advantage of accelerated depreciation options like bonus depreciation, it's essential to have a clear understanding of your asset management strategy. Will you hold onto these assets long-term, or do you frequently buy and sell them? Shannon emphasized the importance of this foresight to avoid unexpectedly hefty tax bills due to depreciation recapture.

Actionable tip: If your business owns high-value assets, consult your accountant or tax advisor. Discuss the potential impact of depreciation recapture and explore strategies to manage this liability effectively.

What you'll hear in this episode:

05:21 Consult tax advisor before selling business or assets.
07:26 Foundational business resources for successful startup.

If you like this episode, check out:

Should I Hire a Tax Strategist?

How to Read Your Tax Return

S Corp Salary Explained Like a 3rd Grader

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The information contained in this podcast is intended for educational purposes only and is not individual tax advice. Please consult a qualified professional before implementing anything you learn.