Tax is triggered by specific events. For example, the sale of an investment or
other asset will often trigger tax.
Assume that you buy some shares for $100 and later sell the
shares for $500. You will have a $400
profit on the sale. If you make a
business of buying and selling shares, the $400 increase in value will be taxed
as ordinary income. If you bought the
shares as an investment, the $400 increase in value will be taxed as a capital
gain. As discussed in Tax Primer 6,
whether you are in the business of buying and selling shares or merely an
investor is a question of fact.
The comments in this chapter will assume that you are an
investor.
If you are an investor, you will realize a capital gain when
you sell an investment that has increased in value. The sale of certain types of investments,
however, may result in the taxation of both a capital gain and ordinary
income. For example, assume that you
purchase a building for $1 million and rent it to tenants. Income tax law allows you to depreciate the
cost of the building (but not any associated land) over specific periods of
time (a bit each year). You claim this
depreciation expense (in tax jargon, capital cost allowance) as a deduction
against rental income, thereby reducing the tax payable on the rental
income. For the purposes of this
example, assume that you have claimed $400,000 in total depreciation on the
building over your years of ownership. Eventually,
you get tired of being a landlord and decide to sell the building. If you sell the building for $1.4 million,
you will pay tax on two different amounts.
As you probably expect, you will have a capital gain of $400,000 (the $1.4
million sale price less the $1 million cost).
However, you will also have ordinary income of $400,000 (equal to the
past depreciation claims). Since the
building did not in fact go down in value, you have to “recapture” the depreciation
deductions that you claimed in the past.
When depreciating a building for income tax purposes,
remember that the income tax saved through the depreciation claims will have to
be repaid to the government at some future date. Think of that tax “saving” as a form of
interest-free loan. It makes sense to
invest the tax savings to earn more income.
If you use the tax savings for personal consumption (such as a
vacation), remember that the tax savings might have to be repaid some day. The tax savings is not really a savings –
just a deferral.
If the asset actually depreciates in value over time at a
rate that is at least equal to the depreciation claimed for income tax purposes,
no recapture will arise on sale of the asset.
This is the case with most cars, for example.
When you claim depreciation for income tax purposes, the
depreciation is called capital cost allowance.
The cost that has not yet been depreciated is called the undepreciated
(as in not yet depreciated) capital cost of the asset.
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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.