11.13.23
Many construction businesses find themselves with equipment or vehicles they no longer need. If you’re thinking about selling or trading in such assets, be sure to consider the tax consequences.
You may not expect to owe taxes when you sell a piece of equipment or vehicle for less than you paid for it, but that’s what often happens with business assets — especially if they’re fully depreciated. Let’s first take a look at the different ways that construction companies can recover the costs of business assets. Then we’ll look at the tax implications of a sale.
Cost Recovery 101
Business equipment and vehicles are generally considered capital assets, the costs of which are recovered through depreciation deductions over their useful lives. In practice, however, these costs are usually recovered more quickly by using one of the following methods:
Accelerated Depreciation. Under the modified accelerated cost recovery system (MACRS), most construction equipment and vehicles are classified as five-year assets. So, for example, assuming the “half-year convention” applies, 20% of the cost would be deducted in year one, 32% in year two, 19.2% in year three, 11.52% in years four and five, and 5.76% in year six.
Section 179 Expensing. Internal Revenue Code Sec. 179 currently allows you to deduct, rather than depreciate, up to $1,160,000 in equipment, vehicle and other qualifying asset costs. The deduction is phased out dollar for dollar to the extent your total investment in Sec. 179 assets for the year exceeds $2.89 million.
Bonus Depreciation. For assets placed in service after 2017 and before 2023, bonus depreciation allows you to deduct up to 100% of the cost of equipment, vehicles and other eligible assets. However, bonus depreciation is currently being phased out. The good news is it still allows you to deduct up to 80% of the cost of assets placed in service in 2023. After this year, the percentage declines by 20% annually until bonus depreciation is scheduled for elimination after 2026.
Selling Depreciated Assets
When you sell or trade in a used asset, you may trigger a taxable capital gain or “recapture” of previous depreciation deductions. Recapture is generally taxable at ordinary income tax rates but, in some situations, it can be taxable at both ordinary rates and capital gains rates.
If the sale price or trade-in value is greater than your basis in the asset, then the difference is a taxable gain. If that gain is less than the amount of depreciation you’ve claimed on the asset, then it’s considered depreciation recapture and taxed at ordinary income tax rates as high as 37%. If it exceeds your previous depreciation deductions, the gain attributable to depreciation is taxed as ordinary income and the excess is treated as a capital gain, typically taxed at 15% or 20%.
Following are three examples to illustrate how this works. To keep things simple, let’s assume that:
- You’re a sole proprietor in the 35% tax bracket,
- You’re disposing of only one piece of equipment this year, and
- You didn’t claim losses on any business property in the last five years.
When you dispose of several assets in one year, your gains and losses are netted against each other, and the tax consequences depend on whether you have a net gain or loss and the character of that gain or loss. Also, certain deductible losses on business assets in the last five years can convert capital gains this year into ordinary income.
Example 1. Suppose you bought a midsized excavator in 2020 for $200,000 and you deducted the entire cost that year using bonus depreciation, reducing your basis to zero. This year, you decide to buy a larger excavator and receive $100,000 in trade-in value for the old one. The entire $100,000 is depreciation recapture, resulting in a $35,000 tax bill ($100,000 x 35%).
Example 2. Apply the same facts as Example 1, except you’ve been depreciating the excavator pursuant to MACRS. Through 2022, you’ve taken $71,200 in depreciation deductions, reducing your basis to $128,800. Trading in the excavator for $100,000 results in a $28,800 loss.
Example 3. Apply the same facts as Example 2 except that, because of a severe shortage of midsized excavators, you’re able to sell yours for $218,800 — resulting in a $90,000 gain. The amount of that gain attributable to depreciation recapture ($71,200) generates $24,920 in ordinary income taxes ($71,200 x 35%). The remaining $18,800 in gain is a long-term capital gain, resulting in $2,820 in taxes ($18,800 x 15%), for a total tax of $27,740.
No Surprises
As you can see, the circ*mstances of a transaction involving equipment or vehicles greatly impact the tax consequences. Before committing to any deal, contact us or consult your CPA.
