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Real Estate Investors’ Potential Tax Trap: Depreciation Recapture

Depreciation is one of the great tax advantages to real estate investing. But as the tax man giveth, he taketh away. With real estate, the taketh-ing is by means of depreciation recapture. Recently, in response to Mike’s article about depreciation deductions for real estate investors, a reader asked about the effect of those deductions at sale. In this article, I’ll describe how depreciation recapture works with an example and a link to a depreciation recapture calculator.

How Depreciation Recapture Works with Real Estate Investments

Under current tax law, residential rental property generally is depreciated over 27.5 years. This means that each year you can offset rental income by the cost basis of your rental property (but not the land) divided by 27.5. For example, if you a property costs $125,000 (price plus rehab costs), and $100,000 represents the portion of costs allocated to the home, a depreciation deduction could be taken each year in the amount of about $3,636. This amount can offset rental income, and along with other deductions such as interest, insurance and repairs, may result in a net tax loss for the year. As long as your income doesn’t disqualify you from taking the deduction, you can also deduct up to $25,000 of losses from your ordinary income. So, depreciation can be a powerful financial benefit to real estate investors.

But there’s no free lunch. Depreciation recapture comes from the Taxpayer Relief Act of 1997, which imposed the higher tax rate for all IRC Section 1250 gains, which for our purposes means all rental property investments. When you sell the property, you must “recapture” any depreciation you’ve taken (or could have taken). Consequently, a portion of your gain equal to the amount of depreciation you’ve previously taken is taxed at 25%, rather than the 15% long-term capital gains tax rate.

An Example of Depreciation Recapture upon Sale of a Rental Property

Returning to our example, assume you purchase a rental property for $125,000. Over the period you plan to own the home, let’s assume you depreciate $25,000 per IRS rules, and then you sell the property for $160,000. At sale, your adjusted basis in the property is $100,000 ($125,000 – $25,000) resulting in a tax gain of $60,000. Because your gain exceeds the amount of depreciation taken, the depreciation recapture rule will apply. As a result, your tax will not be $9,000 ($60,000 x 15%), but $6,250 ($25,000 x 25%) +$5,250 ($35,000 x 15%), or $11,500. Thus, the depreciation recapture rule costs you $2,500 more in taxes in this example.

I recently came across a calculator that will show you the tax on your gain, including the depreciation recapture. You can access the calculator here. The point of this particular calculator is to promote the benefits of a 1031 exchange, but it may prove helpful in getting an idea of your tax liability.

The Tax Upside and Downside to Depreciation for the Real Estate Investor

Depreciation recapture is a reality if you sell a property for a gain and pocket the money. However, the depreciation deduction can still represent a net gain to the investor. First, your federal marginal tax rate at the time of taking depreciation deductions may be 28%, while the tax on that depreciation at the time of sale will be 25%. Second, you’re repaying today’s tax savings with tomorrow’s dollars. Third, if the gain attributable to the building is less than the amount of depreciation taken, then you may not have to recapture all of the depreciation. This could happen, for example, where the rental property has aged significantly, and the land becomes the more valuable part of the property.

Finally, by taking advantage of a 1031 like-kind exchange, you may be able to further defer all taxes on the sale, including depreciation recapture. Previously, we’ve written about 1031 exchanges that, in addition to discussing tax avoidance strategies, also resurrects the word “moxie.” (That part was Mike). As always, you should consult a tax professional before making any tax-planning decisions. For our part, we’ll be returning to the topic of 1031 exchanges in the future to provide a further look at 1031 exchange options, and I’ll see what I can do about using terminology strictly from this century.

{ 10 comments… add one }

  • Alex Morrow January 3, 2008, 5:54 pm

    Thanks Mike for writing this article. I truly appreciate it! It provides me with a better understanding of how depreciation hits you in the end.

  • Fixemup Terry January 5, 2008, 12:37 pm

    “Depreciation recapture” has always been low on my list of interesting real estate topics, somewhere down there by “grout”. Yet, your article did a great job of giving me a better appreciation of it.

    I liked the point about using tomorrow’s dollars when you pay the recapture. Also, I wasn’t aware of the 1031 angle.

    Good article!

  • Scottsdale Condos July 2, 2008, 1:03 pm

    Great post, I really enjoyed it. I will have to bookmark this site for later.

  • Emerald Isle October 5, 2008, 8:09 pm

    Does the recapture apply if your income is such that you can’t take the deduction?

  • Chris March 14, 2009, 9:37 pm

    Thanks Mike for clarifying something somewhat mystic.
    I once depreciated and was hit with the huge tax bill when I took the profit. Another time I did not depreciate and was glad I did not get hit with the tax, but this clearly shows its better overall to take the depreciation. Just have the money to pay the IRS when you sell the building.

  • Ray Graziano December 14, 2010, 12:27 pm

    I bought a 12 unit in 1978 and have fully depreciated the improvment, staraight line. I understand the 25% deprciation recapture and the 15% long term capital gain rate but what about all the purchased appliances, frunace, roof etc that have either been fully depreciated or not? Is there a difference if the improvements were depreciated on an accelerated vs. straigh line basis? Thanks for any help

  • Mike January 29, 2011, 5:51 pm

    Ray,

    You’ll need to allocate a sale price among the assets (or at least of the asset “classes”). Capital improvements, like the roof replacement, will generally increase the basis in the building itself and the depreciation of that improvement will reduce the basis. As to applicances, a portion of the sale price would be separately allocated to those assets since they are a different class than the building. The allocation of the purchase price would be according to fair market value of the assets. Generally, for appliances, I would likely allocate a portion of the price equal to the adjusted basis–no gain; no loss. The remainder of the price is allocated between building and land using the percentage allocation used to calculate depreciation at purchase. All depreciation taken on the building and improvements would be subject to recapture with the remainder as capital gain; gain on the appliances, if any, would be ordinary income; gain on the land would be all capital gain.

  • Mike Young July 28, 2012, 7:24 am

    I bought properties in 70s-how does recapture apply to me.

    I just got out of the properties under 1031-so I should have no recapture under the new properties-correct?

    Thanks
    Mike

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  • jojo de los reyes March 23, 2014, 3:52 pm

    We rented the home we used to live in for seven years over the last six years. The rental income is less than my PITI but I still have to do the depreciation.Since I did not benefit from the depreciation, why should I pay depreciation recapture tax ?

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