If you’re like some rental property owners, you’d never heard of the term depreciation recapture or even understand the logic behind it until your first rental goes up for sale. While owning a rental property offers you the benefit of potential steady cash flow, you may be unaware of the range of taxes you are subjected to when you decide to sell your property.
In this article, you’ll learn more about depreciation, depreciation recapture, and how to avoid depreciation recapture tax upon the sale of your rental property.
The IRS defines depreciation as a capital expense that is the mechanism for recovering your costs in an income-producing property, and must be taken over the expected life of the property. It allows you to deduct the cost of buying and improving a property over its useful life.
When you buy a residential rental property, the IRS allows you to take out a tax deduction based on the potential depreciation in the value of the home over 27.5 years. You can take out these deductions as soon as you put the rental property into service. Most residential rental properties are depreciated at the rate of 3.636% of its cost basis annually.
Using a simple case study, let’s say you purchased a fourplex property on January 1st for $300,000.
The depreciation calculation would appear like this:
- The Cost Basis (Purchase Price) deducted by the land value will equal the building value.
- The building value divided by 27.5 will give you your annual depreciation deduction.
Assuming that the value of the lot on which the fourplex sits is $75,000, the calculation would look like this:
- $300,000 deducted by $75,000 equals $225,000 for the building value
- $225,000 divided by 27.5 years equals $8,182 approximately.
Your allowable annual depreciation deduction amount is $8,182. However, when you sell off the rental property for a gain, the IRS will need to get some of those depreciation deductions or gains back. This is known as Depreciation Recapture. Below is everything you need to know about rental property depreciation recapture.
What is Depreciation Recapture on Rental Property?
With most property owners deducting depreciation over the useful life of their property, the IRS introduced the Depreciation Recapture or the IRC Section 1250. When you take out these deductions in the name of depreciation, the deductions are considered as a gain since it lowers your cost basis and taxable income.
So, when you sell the property for a gain, the IRS requires that you pay back a certain percent of the depreciation deductibles you have collected over the period the property was in service. A quick example of calculating depreciation recapture on the sale of a rental property based on our case study.
- You purchased a fourplex for $300,000 but since you need to exclude the cost of the land, this leaves you with a building value of $225,000.
- You take out a depreciation of $8,182 each year, for 11 years. The total depreciation deducted is $90,002.
- Your adjusted cost basis for the fourplex is now $134,998 (To get the adjusted cost basis, you simply deduct the total depreciation from the building value)
- Eleven years down the line, you decide to sell the property for $500,000, and your realized gain is $365,002.
- Since you realized a gain upon the sale of the fourplex, the IRS will require that you pay up to 25% on the part of the gains tied to your total depreciation deductions. So, if your ordinary-income rate is capped at 25%, then it would be ($90,002*.25) which equals a depreciation recapture of $22,500
- The remaining portion of the gains realized will be taxed at the long-term capital gain tax rate by the IRS. If your capital gains tax bracket is at the highest (i.e. 20%), then your capital gains tax would be ($275,000*.20) which equals a capital gains tax of $55,000.
So, upon the sale of the fourplex, you’ll be looking at $77,500 in taxes. When filing your tax, you will need to report your depreciation recapture on IRS Form 4797. Please reach out to a professional tax advisor for assistance with your specific situation.
How to Avoid Depreciation Recapture Tax on Rental Property
While depreciation recapture is required by the IRS upon the sale of a rental property or when the property cost has been fully recovered, there are several legal ways you can sell your depreciated rental property without having to deal with tax penalties.
Selling the Property for a Loss to Avoid Depreciation Recapture Tax
This is one of the easy yet difficult ways to avoid depreciation recapture tax upon the sale of your rental property. You are not required by the IRS to pay for depreciation recapture tax if you sold your home for a loss.
For example, if you held the fourplex for 11 years with a total depreciation deduction of $90,002 over the period but decide to sell the property for $100,000 due to a collapsing market. In this scenario, you will not have to pay for depreciation recapture instead you would have to report a loss of $34,998 (adjusted cost basis minus selling price).
If you owned the rental property or fourplex in our example for more than a year, you would be able to file this loss under the Section 1231 loss category. This means that you can use the loss to reduce your tax liability during your current or past two years of taxable income.
Do a Like-Kind or 1031 Exchange to Avoid Depreciation Recapture Tax
Typically, when you sell a real property and you have a gain, the IRS expects that you pay taxes on the realized gain. However, the IRC Section 1031 allows you to defer the payment of capital gain taxes and depreciation recapture if you structure your transaction as part of a like-kind or 1031 exchange.
So, what is a 1031 or like-kind exchange? A 1031 exchange allows you to defer the payment of capital gain taxes or depreciation recapture taxes if you reinvest the sale proceeds of your real property into the purchase of a replacement real property while adhering to IRS guidelines.
Going by our earlier fourplex example;
|Taxable Sale||1031 Exchange|
|Federal Tax Liability||$77,500||$0|
If you study the table closely, you’d notice that the tax bill to the investor would be $77,500 and the portion attributed to depreciation recapture was a little above $22,000. Fortunately, the 1031 exchange section showed that the investor was able to defer the payment of depreciation recapture or even capital gains.
So, if your goal is to avoid the payment of depreciation recapture through the use of 1031 exchange, you can achieve that by reinvesting the proceeds of the sale of your rental property into another rental property continually. By doing that, you can defer paying depreciation recapture taxes until your demise and your kids may be able to sell the property tax-free.
Final Thoughts on How You Can Avoid Depreciation Recapture Tax on Rental Property
Even though the 1031 exchange or depreciation recapture process may appear simple on paper, it involves a series of rules and not so simple steps. Remember that the examples used in this article are overly simplified. Also, rental property tax laws are complex and subject to constant modifications.
Before you start the sale process of your rental property or decide to avoid the payment of depreciation recapture tax, please reach out to a qualified tax accountant to discuss your situation.