Selling Business Property - Capital Gain? Ordinary Income? Help?

I had a question recently about the sale of a business property (house/office and land) and how it would be taxed after the sale.  In this case, the property owner had used it for his law practice for many years....you've seen the small houses near the "downtown" area of your local community; many are occupied by attorneys as their offices.

So, here are the facts.  He bought the property in 1984, used it to run his law practice, and now has sold it for about twice the purchase price.  For simplicity sake, he bought for $50,000, and sold in 2014 for $100,000.  Of course, the property is fully depreciated, so his basis in the property is $0. (Basis = sales price - depreciation) His question for me?  How much tax will I owe?

It would be nice if I could tell him that the gain is all Long Term Capital Gain(LTCG), taxed at 15% (for his tax bracket)....so you owe $15,000 in taxes on this sale.  However, there's this little problem about the depreciation he's taken over the years. One of the nice things about taking a depreciation deduction every year on a property is that it's an allowable expense to reduce net income (thus, taxable income), but doesn't require cash.  Quick example: If you buy office supplies for your business, you pay with cash and you take a deduction for this business expense.  Depreciation allows you to take a deduction, but there is no outlay of cash! Nice deal! When the property is sold, it's time to "pay the piper".  The IRS requires you to treat the amount you depreciated as Depreciation Recapture, subject to taxation at a 25% rate. 

In our simplistic example, the $50,000 original basis is adjusted to $0 because of depreciation.  When the property is sold for $100,000 the first $50,000 of gain is considered Depreciation Recapture (taxed @ 25% = $12,500 in tax); the second $50,000 of gain is LTGC (taxed @ 15% = $7,500 in tax).  Total tax on the sale - $20,000.  This is a simplistic example and does not include other potential factors....trying to make it easy to understand, not trying to pass the CPA exam!!!

If you need help understanding the tax impact of your situation, visit our website (http://leonardcpa.net) or send me an email (lennelms@bellsouth.net)!

Blessings!

Len Nelms, CPA

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