2.5.2. Calculating Capital Gains
When an asset is sold, profit is determined for tax purposes by the difference between the sales price of the asset and its adjusted cost (tax) basis. Recall that tax basis is an asset’s purchase price adjusted upwards for transaction costs including state and local taxes and the cost of improvements, and downwards for distributions, depreciation, and losses from casualty or theft.
While depreciation expense deductions reduce income tax from year to year, they are really just a tax deferral. For this reason, depreciation expense is also deducted from the asset’s adjusted cost basis. Accumulated depreciation will get taxed in the year the asset is sold. This is called depreciation recapture.
Depreciation recapture is important, because it determines how much of the profit from an asset’s sale will be considered a capital gain and how much will be taxed differently. For personal assets, if taxable income is less than the amount of depreciation to be recaptured, all the profit is considered ordinary income. If taxable income from the sale of the asset is greater than depreciation recapture, income up to that amount is ordinary income, with the excess being a capital gain.
For real assets (i.e., buildings), depreciation is recaptured at a maximum 25% rate, higher than the capital gains rate but lower than the ordinary income rate for most investors.
When partners or members of a limited partnership or LLC sell their interests, whether their profit is taxed as ordinary income or capital gain depends on the kinds of assets that make up their tax basis. The assets that make up a partnership’s outside basis may include cash, depreciable property, accounts receivable, and inventory. When a partner sells her interest in a partnership, profits are considered capital gains unless the profit is generated by:
• depreciation recapture
• unrealized receivables
• appreciation of inventory in excess o