Question

What's this recapture thing all about, anyway? We tell people that if they sell an asset (either a capital asset or a Sec. 1231 business asset) at a gain, if held more than one year, we will give them a favorable (i.e., low) tax rate on the gain. Then we come back and tell them "Wait, that is only on the part that is not recaptured as ordinary income!" What is going on? Why have the recapture rules at all? Exactly what is being recaptured? What is the "wrong" that the government is attempting to "right", or in other words, what is the "unfair" thing the tax laws are attempting to prevent from taking place by having recapture rules?

Answer 1

In tax accounting recapturing is the process in which taxable income is adjusted higher because of the fact that certain deductions were made in the previous period.

To explain why the recapture rules exists, what is being recaptured and what is the “wrong” that the government is attempting to "right" we should understand the context. Suppose that a business sells an asset and adds back some the depreciation then this will be known as depreciation recapture. This recapture, in plain and simple words, is the gain that has been received from the sale of the depreciable asset that must be reported as income. This recapture is assessed when sale price of the asset in question exceeds the adjusted cost basis or the tax basis of the asset. This difference is reported as income and hence is recaptured in that sense.

Now the reason why the recapture rule exists is because it allows IRS (Internal Revenue Service) to ensure that tax is collected on any profitable sale of asset that the taxpayer had used to offset his/her taxable income. It should be noted that depreciation amount can be used to deduct ordinary income and as such any profit or gain that accrues from the sale of asset has to be reported as ordinary income and not as the desirable capital gain.

The “wrong” that the government is attempting to "right" is the inappropriate deduction or tax credit that the taxpayer took to avoid paying taxes or to lower his/her tax liability. The situation is corrected and made right as the person or individual in question has to pay taxes on previous year’s income if the deduction was not appropriate.