Tax efficiency of alternative investments-Reading 17

"Private equity and venture capital generally have favorable tax treatment because the capital gains tend to be long term. In addition, certain fees and expenses (e.g. management fees) may be a deduction against ordinary income. Unless the deferral period is long, however, the savings may not be important, especially because the depreciation must be recaptured at high tax rates. " I did not undesrtand depreciation part. In what ways can it affect tax efficiency of private equity or venture capital negatively?

So depreciaton recapture is one of those logical seeming things that is a trap for the unwary. You invest in some PE fund and they buy a bunch of stuff and suppose (for fun) that you are in the 15% marginal tax bracket. Every year, you will get a pass-through depreciation allotment on your K-1 which you can deduct from your income (subject to a billion and a half incomprehensible parts of the tax code). But for each $100 worth of depreciation, you save $15. Years go by and the PE firm sells the stuff for more money than they bought it. Alas, you’ve been telling the IRS that you are losing money through depreciation, but you are actually gaining money. So the IRS says that if you have deducted $100000 for depreciation, your first $100000 in gains is taxed as regular income. But now you are in a new tax bracket as you just got a big lump of income so instead of repaying the 15% you saved, you now repay at 33%. Further, if your income is rising during this period you are getting a double whammy of lumpy income as well as increasing marginal tax bracket. Very sneaky of those IRS guys… Edit: Typos

When I read it first, it really did not make any sense. Yet again there is a reasonable explanation. Thank you Joey!!