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.