How to Handle Section 179 Recapture on Disposition
Learn how an early asset disposition or change in business use can reverse a prior Section 179 deduction, resulting in an ordinary income tax adjustment.
The Section 179 deduction allows businesses to expense the full cost of qualifying equipment in the year of purchase. The Internal Revenue Service (IRS) provides this benefit with the expectation that the asset will be used for business over its expected useful life. When an asset is taken out of service early or its business use substantially decreases, the tax benefit must be adjusted. This adjustment process is known as recapture, which is the method the IRS uses to reclaim a portion of the initial tax deduction to align the benefit with the asset’s actual business use.
Triggers for Section 179 Recapture
Recapture of a Section 179 deduction is initiated by specific events that occur before the end of the asset’s designated recovery period. The most straightforward trigger is the disposition of the property. A disposition includes a sale, exchange, trade-in, or gift. A casualty or theft that leads to the asset’s removal from service is also considered a disposition event that can trigger recapture.
A reduction in the asset’s business use is another trigger. If the percentage of qualified business use drops to 50% or less during any year within the asset’s recovery period, recapture is required. This rule applies even if the business still owns the asset. For instance, if a company purchases a vehicle and uses it 100% for business in the first year, but its business use falls to 40% in the third year, the recapture rules would apply.
The recovery period, determined by the Modified Accelerated Cost Recovery System (MACRS), is the timeframe over which the recapture rules are applicable. For most business equipment and vehicles, this is five or seven years. A transfer of the asset upon the death of the owner is an exception and does not trigger recapture.
Calculating the Recapture Amount
When Section 179 property is sold or otherwise disposed of, the recapture amount is calculated based on the gain from the sale. The amount to be recaptured is the lesser of the gain realized on the disposition or the total Section 179 deduction that was claimed on the asset. This recaptured amount is treated as ordinary income.
When the full cost of an asset is deducted under Section 179, its adjusted basis for tax purposes becomes zero. Therefore, the entire amount received from a sale, up to the amount of the original deduction, is considered a gain.
Consider a business that buys equipment for $20,000 and elects to deduct the full amount using Section 179 in Year 1, reducing the asset’s adjusted basis to $0. In Year 3, the business sells the asset for $12,000. The gain on the sale is the sale price minus the adjusted basis, which is $12,000 ($12,000 – $0).
The recapture amount is the lesser of the gain ($12,000) or the Section 179 deduction taken ($20,000). In this case, the business must report $12,000 of recapture income. If the asset had been sold for $22,000, the total gain would be $22,000. The recapture amount treated as ordinary income would be limited to the original $20,000 deduction, with the remaining $2,000 gain treated as a capital gain.
Reporting Recapture Income
The recapture amount must be reported to the IRS on Form 4797, Sales of Business Property. This form is used to report gains and losses from the sale or disposition of business assets and includes a specific section to handle recapture.
The gain from the disposition, including the recaptured amount, is reported in Part III of Form 4797. This part is used to calculate the gain and determine how much of that gain should be treated as ordinary income due to depreciation recapture.
The recaptured amount is not considered a capital gain; it is treated as ordinary income. This means it is taxed at the taxpayer’s standard marginal income tax rate, which can be higher than preferential long-term capital gains rates.
After the gain is calculated on Form 4797, the resulting ordinary income figure flows to the taxpayer’s primary tax return. For a sole proprietor, this amount would be carried over to Form 1040. For corporations or partnerships, the income would be reported on their respective returns, such as Form 1120 or Form 1065.