Most tangible assets lose value over time. Equipment wears out, buildings require regular maintenance and upkeep, and computers become obsolete. To reflect the steady loss of value in capital assets, the tax laws allow you to claim depreciation deductions. Those deductions give you immediate tax benefits, but they also have implications for the future if you decide to sell the asset.
How depreciation affects capital gains
You have to take into account the depreciation deductions you've claimed on an asset in calculating the amount of capital gain or loss on its sale. Whenever you claim depreciation, it reduces the tax basis of the asset in question.
When you sell the asset, your gain will be equal to the sales proceeds minus the asset's tax basis. Because depreciation reduced that tax basis over time, any capital gain will be correspondingly larger than it would have been if you hadn't claimed depreciation deductions. Conversely, if you have a capital loss, it will be smaller than it otherwise would have been.
As an example, say you spent $1,000 on an asset with an anticipated 10-year lifespan. You take $100 per year in depreciation, and four years later, you sell it for $600. If depreciation rules didn't apply, you would have a $400 capital loss. However, because you claimed four years of $100 annual depreciation deductions, your tax basis in the asset fell to $600. You therefore have no gain or loss on the sale.
Depreciation recapture
Sometimes, depreciation doesn't accurately reflect the extent of an asset's change in value. If you sell an asset for more than its depreciated value, then you'll typically have to pay depreciation recapture tax on any gain attributable to the depreciation.
For instance, in the above example, say you sold the asset for $700. In that case, you'd have a $100 gain, and it would all be subject to dividend recapture tax because it is less than the $400 in depreciation deductions you took.
Dividend recapture amounts get taxed more harshly than regular capital gains. A maximum rate of 25% applies, as opposed to maximums of 15% to 20% for capital gains. The higher rate compensates for the fact that the taxpayer gets an ordinary deduction at their full marginal tax rate for the initial depreciation allowance.
To suggest that depreciation offsets capital gains tax misunderstands the idea of how depreciation works. Essentially, by recognizing the loss of value in an asset, depreciation gives you a more timely tax deduction than you would get if you only had the capital gains and loss system to use for depreciable assets.
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