Depreciation makes owning and improving your commercial or residential assets easier, which is good news considering all the advantages of investing in real estate. Depreciation recapture, however, may eat a significant percentage of your profits, which may sour your experience of property ownership. Luckily, you can prepare yourself for this possible outcome and even take advantage of a tax opportunity that will let you sidestep both capital gains and depreciation recapture entirely!
What Is Depreciation Recapture?
Depreciation is a tax deduction that you get to take on your property. It’s meant to make real estate investment a more manageable endeavor. The total amount that you deduct as a result of depreciation, however, is treated as a form of income by the IRS and, as a result, is itself subject to tax. The name of this tax is called “depreciation recapture”.
How Does Depreciation Work?
Depreciation is when you deduct the cost of purchasing and repairing a real estate property from your income taxes. Depreciation is spread out over the course of your property’s useful lifetime, the IRS’s term for the amount of time a property is said to be capable of generating cost-effective income. For rental properties, the useful life is 27.5 years, and for retail and commercial real estate the useful life is 39 years.
To qualify for depreciation, your property must meet the following stipulations:
- You must be the property owner.
- You must use the property to make money as part of a business.
- The useful life of your assets must be determinable. This means that the wear and tear is observable in various ways and that your assets, ultimately, go down in value as a result.
- You must intend to own the property for more than a year.
Land does not qualify for depreciation because cleaning, planting, and landscaping are all classified as part of the price of land. Since land doesn’t count toward depreciation, you have to subtract the cost of the land from the cost of your property when making your calculations. Some examples of improvements that do count toward depreciation include roof replacement, air conditioning, and new additions to the property.
Depreciation is usually calculated using The General Depreciation System (GDS). GDS works by applying the declining-balance method rate on a non-depreciated balance. So, if your property is valued at $1,000 and is depreciated by 25% every year, which is the current tax rate for depreciation, then your deduction the first year is $250, $187.50 the second year, and so on for either 27.5 or 39 years depending on the type of property you own.
What is Depreciation Recapture for Rental Properties?
Depreciation recapture can significantly eat into the profits you make from selling your rental property. Part of your income is going to be taxed as a capital gain. You may even end up paying the maximum 20% rate on long-term gains! The technical term for the amount that’s subjected to the recapture is known as the “unrecaptured section 1250 gain”. Depreciation gets taxed at an even greater rate of 25%! That’s a whopping recapture.
What is a Simple Example of Depreciation Recapture?
Let’s do some math so you can see just what your gains will look like after recapture. Imagine buying a rental property for $2 million (land not included, of course). After 10 years, you would have deducted $500,000 thanks to depreciation. That gives you a stake of $1.5 million in the property. If the asset is sold for $5 million, that’s a profit of $3.5 million. Let’s apply the capital gain tax at a rate of 20% to $3 million, and apply the recapture rate of 25% to the $500,000 that was deducted thanks to depreciation. That means you’ll have paid $600,000 in capital gains and $125,000 in depreciation recapture. That’s a lot!
What Tips are there for Calculating Your Taxes?
Don’t want to pay all those taxes? How about a 1031 Exchange?! That’s when you use the income generated by the sale of a property to purchase another property of equal or greater value soon after. When this is done, you put off paying capital gains taxes and depreciation recapture. A 1031 exchange is also a great way to diversify your real estate investments or get a property that requires lower maintenance.
Additionally, when you sell a rental property you get to deduct any previously non-deductible passive activity losses. Passive activity losses are loses that occur only in the course of generating passive income. The difference between passive and active income is your material participation in it. There are seven means by which material participation can be defined, the most common of which is working at least 500 hours on your business over the duration of a year. Rental activities, even if there’s material participation, is considered a passive activity. This does not, however, apply to “real estate professionals”.
What are Tax Implications When Selling Real Estate?
Depreciation recapture is applied to the gain or the total amount taken in depreciation, whichever of the two is less. So, if your gain is $100,000 but you deducted $500,000 thanks to depreciation, you’d apply to the depreciation rate of 25% to your $100,000 and pay $25,000 to the IRS. Depreciation recapture does not apply in the event of a loss. Depreciation recapture also does not apply to the sale of anything other than property. That means furniture and artwork, for example, is not subject to depreciation recapture.
You always have the option of not claiming depreciation, and of changing your mind and claiming it in retrospect by filling out the right tax forms. What you can’t do, however, is not pay for depreciation recapture. That’s because depreciation recapture is applied to depreciation that was “allowed or allowable”. Womp womp! This is thanks to Internal Revenue Code section 1250(b)(3). So, you might as well claim depreciation because the IRS is going to act as if you did!
What are Additional Resources About Depreciation Recapture?
As you can tell, depreciation and depreciation recapture are profoundly important when it comes to your taxes. You can’t even get around depreciation recapture unless you do a 1031 exchange! So, here’s some additional information you’ll want to read:
- Unrecaptured section 1250 gain ( IRS Publication 523)
- Residential Rental Property (IRS Publication 527)
- Sales and Other Dispositions of Assets (IRS Publication 544, especially the section in Chapter Three dealing with depreciation recapture)
- Instructions for Schedule D (The worksheet on page D-9 can calculate the depreciation recapture tax)
- FAQ about Depreciation and Recapture (From the IRS FAQs)
Depreciation makes buying and improving a rental or commercial investment property easier. However, when it comes time to sell the property depreciation recapture makes things harder! That’s because seeing so much of your profit disappear after putting in so much hard work is hard! So, prepare yourself for your loss by learning all about depreciation recapture, and maybe consider a 1031 exchange to get around paying capital gains taxes and depreciation recapture and keep your wins going!