ERAT and Recaptured Depreciation...WTF?

Okay, so I was a little blown away when I started going over this a couple hours ago, but now have basically boiled this whole chapter down to being very similar to project analysis with the initial outlay (-), the CFATs each year and then adding the ERAT as terminal value to the last year’s CF. Got all that. THe thing I’m having trouble with is this concept of recaptured depreciation. They state that we’re accounting for extra depreciation that was initially taken in anticipation of the decline in the asset that never materialized. Why, then, do we SUBTRACT the recapped depreciation when getting the capital gain on the property sale??? If we took too much out initially, wouldn’t we be adding it back down the line. Sorry if this is an easy concept, but it just doesn’t make sense to me. Also, if anybody can add anything clever to this chapter for my notes…well, that would just be THUUUPER!

Because you took a tax deduction for the depreciation that you weren’t really entitled to. Because depreciation on the books was greater than actual depreciation you got to reduced NI (and subsequently taxes) by more than you should have. So the “extra” dedcution you got has to be added back. The adding back is the depreciation recapture. You subtract it because it is real cash taxes that you have to pay on the recapture.

If you took off extra depreciation in anticipation, your book value estimate for the asset would be low. So now when you sell the asset, the gain / loss (difference between sale value and the book value) would be higher. So you would be paying capital gains tax on a higher amount. So you would need to “down” adjust that book value – by giving more of the recaptured depreciation back. So book value = Orig Book Value + Recaptured Depreciation. Or Gain = Gain - Recaptured Depreciation. Does that make sense? CP

^ I think mwvt said it pretty well. Think of it too that the government is going to tax that recapture at the higher tax rate since you were able to deduct originally at the higher rate… as opposed to the LTCG rate.

Think about it conceptually. Depreciation is the wasting of an asset over time. We use conventions to estimate this wasting (DDB, SL etc). When you sell an asset (any asset, not just real estate) you look at what you sold it for and see if it matches up with the depreciation you took. For example Bought for 100 Dep of 50 Sold for 75 You have to recapture 25 Since you got a deduction at say 40% each year, you recapture is at 40%. You are now squared up with reality. Out of the accounting world and back to harsh reality.

Got it boys…makes total sense from all perspectives. Thanks very much. Gain would be too high, and we can’t be havin’ that now, can we?! Yeah, this whole “reality” thing bites. Hope everyone else is having as much fun as me today, trapped in here in Pinkman’s Sweatshop while golden-haired vixens frolic drunkenly about outside in the Wrigley bleachers in the sunny 70F heat.

That’s the way zimzim and pink. Bust this stuff up. Easy points on test day once you have the concept down.

Totally dude. I am crushing this Alt. Investments stuff now. Let’s PRAY that this is actually 10-15% of the material. It must be my “I survived Pinkman’s Sweatshop - CFA Level II 2008” weekend rally t-shirt in fluorescent pink that I’m wearing. Even got some uplifting stickers like “super”, “excellent” and High School Musical’s Zac Efron doing a jig on there!