Lets expand on the example that we had of purchasing the vehicle, that $10,000 car, with cash, and what we are going to do is make it so we sell it before it becomes fully depreciated. The big point here is that we are going to sell the car for something other than its book value. You have to remember that what you are doing with depreciation is that you are formulaically deciding how it is losing value over time and when you make a transaction it is an absolute miracle if the book value of the vehicle is exactly the same as the sales price.

So what we are doing is starting with that $10,000 car, (as shown in cell B2) the same one we started with before where the $10000 is our cost basis. What we are dealing with is a MARR of 5%, (cell B5) which is irrelevant right now, a 35% federal tax rate, (cell B13) and a 7.7% state tax rate, (cell B14.) In recollection, we are looking at the combined tax rate, (in cell B15) where we add up the state and federal rate and subtract off their product, (i.e., combined tax rate = (federal tax rate + state tax rate)-(federal tax rate * state tax rate.)

So let’s take a look over here at what we have lined up, (in column B) as that cash flow that is just the car, and we can think of this as what it looks like from a personal finance basis. There, (in cell B1) is your $10,000 going out the door because w e are purchasing the vehicle, and what we have done is said that we are going to sell this car for about $5000 in the fourth year that you have owned it. Now, look and see what happens with depreciation, remember that depreciation is always going to be the cost basis of the car, that $10000, times the number that is in that modified, accelerated cost recovery system table, MACRS, (in column I.) So in this case what we are doing is seeing that the depreciation in that first year is $10,000, times that 0.2 that is right there, (in cell I2) because we get 20% of that cost basis as depreciation in the first year, (cell C2 = $2,000) and 32% in the second year, which is why we get $3200 for that 2nd year depreciation, (cell C3 = $3200.) So you can follow the pattern in the table until we get down to the year of the sale, (4th year) and what happens there in the early sale in the fourth year is you get half of the depreciation, which means quite literally that we just cut it in half, you don’t do anything fancier than that, (i.e., 10,000 (.12)(.5) =$576 depreciation in 4th year.)

So looking at just the depreciation component, and what we have here in this column for tax savings, (column D) is the reduction in taxes because of the depreciation. So what we are doing here is just taking the depreciation, which is $2000, times that combined tax rate we calculated previously, and that is how much our taxes are going to be lower by because of that depreciation and we are doing that for each of these items down here in the after tax cash just as we did before, all we are doing is taking the pre-tax, that column that says car, we are adding in the tax savings, and except for adjusting the taxes you end up with for getting depreciation wrong relative to the sales price, that is what the cash flow will look like. But here is where this depreciation recapture comes in, what we are looking at is what happens when we sell the car for something other than its book value, but for something less than what you paid for. So we are looking at only ordinary gains and losses on the sale rather than capital gains that are there. So what I am doing with book value is I am just, looking at the equation, (cell F2, Book Value = [cell B10, Cost Basis] – [cell C2, Depreciation]) starting off with its cost basis and I am subtracting off the depreciation in that year, so I am starting off with $10,000 and subtracting off $2000 for first year depreciation and I see the book value after the first year is $8000. Now in the 2nd year, what we have seen is depreciation of $3200 and the book value after the 2nd year is $4800 and so on down the line until you get to the year of the sale, (4th year) you find out that the book value is $2304, (cell F5.) Now note that this book value is different from the amount than we actually sold the car for, the book value is lower. So, what has been going on is over the past couple of years, we have been paying less taxes than we should have and so when you sell the car, Uncle Sam says, “hey, you owe us some money, go ahead and pay the taxes back.” That is what we have been doing here is adjusting those tax payments with this gains tax column and all I am doing here is creating something which is the difference between the sale value of the car, $5000, and its book value, and I’m just multiplying it by that combined tax rate.

For corporations everything is going to work out fine here, as it would for a business. This is essentially paying back taxes that you should have paid before. Please note that this is a zero interest loan so everything works out well and it is not a big deal. However, look at what happens to the after tax cash flow. While if you did not have to pay back all that depreciation, you would have had cash flow for $5, 230.43, (cell E5), but because you have to pay back all that depreciation, or at least the tax value of the depreciation to the government, your positive cash flow is only $4141.89, (cell H5). So again, this is what happens when you sell a business asset, (a car in this instance) at something other than book value.