Last updated on September 17th, 2020 at 09:48 pm
If you’re like some real estate investors, you’d never heard of depreciation recapture on rental property until your first property went up for sale.
“What will my depreciation recapture tax rate for 2019 be?”
“Will I need to do an installment sale?”
“Will a 1031 exchange help me avoid depreciation recapture tax and capital gains tax on my rental property?”
This article will walk through what your depreciation recapture on rental property could be, a couple of depreciation recapture examples, and your best plan to minimize taxes, such as a 1031 exchange. There’s also a depreciation recapture calculator to see what your capital gains will be.
What is depreciation and how can it be recaptured?
Depreciation in real estate is the process used to deduct the costs of buying and improving a rental property. The IRS considers the “useful life” of a rental property to be 27.5 years, and usually 39 years for commercial property.
One of the many reasons investors love real estate is due to the ability to deduct depreciation from their taxes. This depreciation is reported on IRS Form 4797 and only applies to the value of the building, never land. Since depreciation is not a “real” cash expense, it has the effect of improving cash flow by reducing your tax rate.
This gets tricky when a real estate investor sells the property. By taking depreciation, you’re telling the IRS your property is worth less this year than the previous year. Unless you made a capital improvement to the rental property (such as a new water tank or roof), the IRS feels that you have gotten a “free” tax write off. Enter depreciation recapture for your rental property.
Depreciation Recapture on Your Rental Or Investment Property
To make up for this, the IRS’ accounting rules say the amount of depreciation taken each year is subtracted from your rental property’s cost basis, called the “adjusted cost basis.” Depreciation recapture is due when the sale price of the rental property is higher than the property’s adjusted cost basis.
This is in addition to capital gains, and due when you sell a rental property for more than the purchase price. Depreciation recapture tax is typically your income tax rate, which is usually higher than your long-term capital gains tax rate. This is because depreciation was a deduction from your taxable income while you were the owner of the rental property.
With me? Let’s look at a depreciation recapture calculator and example.
Deprecation Recapture for Rental Property Example
The below explains how to calculate depreciation recapture and depreciation recapture tax rate
- Anita acquired a duplex for $500,000 building value (we’ll exclude land value from our example, land can never be depreciated)
- Anita takes $30,000 depreciation each year, for 10 years. Total depreciation is $300,000
- Anita’s “adjusted cost basis” for the duplex is now $200,000
- Anita sells the duplex for $750,000, her “realized gain” is $550,000
- You would think Anita pays capital gains tax on the realized gain. But, she pays $300,000 of the gain at her “depreciation recapture tax rate” and the remaining $250,000 at her capital gains tax rate
- Assuming 28% depreciation recapture tax rate and 20% capital gains tax rate, Anita owes a total of (300,000*.28) + (250,000*.2) = $134,000
- The outcome from this example is an additional $24,000 in taxes. This is due to depreciation recapture tax rate being higher than capital gains tax
Think of “adjusted cost basis” as (purchase price – depreciation taken). Then the “realized gain” is (final sale price – adjusted cost basis). Then, you pay tax on the “realized gain” but at two different rates.
The depreciation recapture calculator amount is easier, that’s (depreciation taken * your tax rate). The final capital gains is then (realized gain – depreciation taken) * your tax rate. Make sense? Try it out below!
Depreciation Recapture Calculator for Rental Property
This depreciation recapture calculator will help you simplify the process of figuring out how much depreciation recapture on your rental property you’ll have. If you’re having an issue with this calculator, please email us at firstname.lastname@example.org. If you don’t know how to apply this depreciation recapture calculator to your specific situation, we recommend getting in touch with a 1031 exchange company.
How can I avoid Depreciation Recapture on sale of a rental property?
You may be thinking “what if I don’t take depreciation and stay out of this mess?” Unfortunately, that doesn’t work to avoid depreciation recapture taxes. The IRS assumes that you are taking the full amount of depreciation available, even if you don’t take it! This is according to Internal Revenue Code Section 1250. There are also instances where your tax bracket was much lower when you were taking depreciation, and higher when you sell. This has the unwanted effect of paying more in taxes than you received a benefit from.
There aren’t many simple options to reduce your taxes when you sell an investment property. The good news is that a 1031 exchange or like-kind exchange is the proven way to defer depreciation recapture on rental property and capital gains tax.
While you may pay taxes eventually, most investors come out ahead by “kicking the tax can down the road.” Many investors also defer taxes until their death. This way, their heirs inherit the properties on a “step-up” basis. Basically, their basis is the fair-market value at time of inheritence. This in essence resets the clock on your capital gains and depreciation recapture on rental property.
Deprecation Recapture Rental Property Frequently Asked Questions (FAQ)
What is my depreciation recapture tax rate for 2019??
Depreciation recapture tax rate is your income tax rate, up to a max of 25%
Can I avoid Depreciation Recapture on rental property taxes by moving into my rental property?
You can delay them, but you can’t avoid them. You are also able to 1031 exchange a property you lived in, but only the non-qualifying use portion is eligible for a tax-deferral. Non-qualifying means the years you did not live in the property and used it as a rental.
Will I owe depreciation recapture on my primary residence?
You’re only able to take deductions from your primary residence if you used it as a home office. Otherwise, you will not owe depreciation recapture on your primary residence.
How is depreciation calculated?
General Depreciation System (GDS) is the most common and usually spreads depreciation in a straight line across 27.5 years for residential buildings. Commercial buildings have more exceptions, but depreciation is commonly in a straight line spread over 39 years.
Will I owe depreciation recapture on rental property if it’s gifted?
Yes. It is true gifts are more favorable than an inheritance in the eyes of the IRS. However, when you are gifted a property the adjusted cost basis stays the same. For example, let’s say your grandfather bought a rental property for $100,000 in 1965 and gifted you the property in 2019. The adjusted cost basis will be extremely low, even if you sell the rental property for $1 million or more, and you will still owe any depreciation claimed.
Ever since the Tax Cuts and Jobs Act was enacted, bonus depreciation has become a more popular tool for real estate investors since it now applies to both new and used property. Using a cost segregation study basically helps you accelerate how quickly you can claim depreciation, called bonus depreciation.
Although bonus depreciation has been a good thing for many real estate investors, it is still subject to recapture. There are some ways around it, though. First, you can reclassify the property as personal property, and use the section 179 exclusion. Second and the subject of this website, you can use the 1031 exchange to defer depreciation recapture taxes. It does not matter whether that’s “bonus” depreciation or not, it still gets taxed. Read more in our article about bonus depreciation recapture.