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Depreciation recapture considerations when planning investments
A major focus of a private equity fund acquiring a target or a business contributing cash to a joint venture is to ensure that it receives depreciation based on the relative fair market value of its contributions to the partnership. Depreciation or amortisation is a critical issue for these entities because this deduction can shield economic income from taxes. Taxand USA investigates further.
If a private equity fund or business investor receives less than its economic share of depreciation, that entity would pay more current income taxes on the same amount of economic income than it otherwise would, which reduces the investors’ return on investment.
The general rule for property contributions to a partnership is that the partnership has a carryover basis in the property equal to the contributing partner’s basis in that property. The partnership’s tax depreciation is based on its property’s tax basis. This means that, under the general carryover basis rule, the partnership’s tax depreciation for appreciated property contributions will be less than the depreciation would be if it were based on that property’s fair market value.
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There are varying points of negotiation when entering into a transaction, and often an overlooked item is the possibility of an ordinary income remedial allocation exceeding the overall accumulated depreciation of a partner with built-in gain. In these cases, a business founder or other partners who are considering taking on a cash investor as a partner will need to consider the potential conversion of a portion of their capital gain into ordinary income over time.