Which of the following is true regarding depreciation recapture?
- It changes the character of a loss.
- It changes the character of a gain.
- It changes the amount of a gain realized.
- It changes the amount of a gain recognized.
A. 2. only
B. 2 and 4 only
C. 3 and 4 only
D. 1. only
The correct answer and explanation is:
The correct answer is:
B. 2 and 4 only
Explanation:
Depreciation recapture is a tax provision that applies when an asset is sold at a gain after depreciation has been claimed on it. This provision ensures that taxpayers do not receive double benefits by deducting depreciation expenses and then later recognizing a lower tax rate on capital gains. Here’s how it affects different aspects of the transaction:
- It changes the character of a gain (True)
- Depreciation recapture changes the nature of a portion of the gain from a capital gain to ordinary income. This means that when a depreciable asset is sold for more than its adjusted basis but not more than its original cost, the gain up to the amount of depreciation previously taken is taxed at ordinary income tax rates rather than capital gains rates.
- It changes the amount of a gain recognized (True)
- Depreciation recapture affects the amount of gain recognized in terms of tax treatment. It does not increase or decrease the total gain realized, but it reallocates a portion of the gain to be taxed differently. Specifically, under IRS Section 1245 for personal property and Section 1250 for real estate, the amount of recaptured depreciation is recognized as ordinary income.
- It does not change the character of a loss (False)
- Depreciation recapture does not apply to losses. If an asset is sold at a loss, there is no recapture since there is no gain to reclassify. Losses are generally treated as either ordinary or capital, depending on the nature of the asset.
- It does not change the amount of gain realized (False)
- The total gain realized is determined by subtracting the adjusted basis from the sale price. Depreciation recapture only affects how the gain is taxed, not the total amount of gain itself.
Thus, the correct choice is B. 2 and 4 only because depreciation recapture changes the character of a gain and the amount of gain recognized, but not the gain realized or the treatment of losses.