Recapture

What Is Recapture?

Recapture is a condition set by the seller of an asset that gives him/her the right to purchase back some or all of the assets within a certain period of time. In this way, it is similar to a repurchase agreement (repo).

Recapture also refers to a situation in which an individual must add back a deduction from a previous year to his or her income.

How Recapture Works

Recapture is a term used in transactional activities between two or more parties. It gives a seller the option to buy back his or her assets at some time in the future following the occurrence of an event. For example, a public company may have a recapture clause, a stipulation that allows it to buy back a percentage of its shares from the market if its cash level exceeds a stated threshold. A pawn shop is another example that allows sellers of household items to recapture them at a later date.

Another form of a recapture can be seen when two parties enter into, say a lease agreement, in which the lessee agrees to pay a fixed percentage of its revenues to the lessor. If the lessee does not generate enough revenue to make the lease contract worthwhile to the lessor, the lessor may choose to terminate the agreement and take back full control of the property until a more profitable tenant is found.

When an entity is required to add back a deduction or credit from a previous year to income, a recapture ensues. For example, when a business sells an asset and must recapture (add back) some of the depreciation, this is known as a depreciation recapture.

Recapturing a Depreciation Deduction

Depreciation recapture is the gain received from the sale of depreciable capital property that must be reported as income. Depreciation recapture is assessed when the sale price of an asset exceeds the tax basis or adjusted cost basis. The difference between these figures is thus "recaptured" by reporting it as income. The recapture is a tax provision that allows the Internal Revenue Service (IRS) to collect taxes on any profitable sale of asset that the taxpayer had used to offset his or her taxable income. Since depreciation of an asset can be used to deduct ordinary income, any gain from the disposal of the asset must be reported as ordinary income, rather than the more favorable capital gain.

The first step in evaluating depreciation recapture is to determine the cost basis of the asset. The original cost basis is the price that was paid to acquire the asset. The adjusted cost basis is the original cost basis minus any allowed or allowable depreciation expense incurred. For example, say a business equipment was purchased for $10,000, and had a depreciation cost of $2,000 per year. After four years, its adjusted cost basis will be $10,000 – ($2,000 x 4) = $2,000.

The depreciation will be recaptured if the equipment is sold for a gain. If after four years, the equipment is sold for $3,000, the business will have a taxable gain of $3,000 - $2,000 = $1,000. It is easy to think that a loss occurred from the sale since the asset was purchased for $10,000 and sold for only $3,000. However, gains and losses are realized from the adjusted cost basis, not the original cost basis. In this case, the business must report a recaptured gain of $1,000.