Depreciation Recapture – How It Works When Selling Property
One of the reasons that keeps people from getting started in real estate is the amount of new “lingo” that has to be learned.
For me, it was similar going from college to dental school. The first couple of months sitting in lecture halls confused the heck out of us. It was as if the professors were speaking a foreign language.
I had no clue what occlusal analysis, mesial, distal, acute apical abscess, or vestibuloplasty was.
So when I first started educating myself about real estate; I could see why so many don’t go much further due to the new terminology that must be learned.
Some terms I had to become familiar with were:
A major reason why so many doctors and other high-income earners are attracted to real estate is the fantastic tax advantages it offers. One of the most powerful is something called depreciation.
But no discussion of depreciation would be complete without also mentioning something called depreciation recapture.
Before we get into what that entails, let’s briefly review how depreciation works.
What Is Depreciation?
One of the rare gifts that the IRS offers tax payers is something called depreciation. It’s a tax strategy that allows you to write off the value of an asset over time.
As most things we buy lose their value with the passage of time (computer, cell phone, etc.), the IRS allows us to take a tax deduction for that declining value (depreciation).
What’s great about real estate is that even though it typically appreciates in value over time, the IRS still allows us to claim depreciation.
Straight-line depreciation is one example that the IRS allow owners of resident occupied real estate to depreciate their property over 27.5 years.
An example would be a property with an improvement value (excluding the land as it can’t be depreciated) of $2.75 million. It would yield $100,000 in depreciation each year over the next 27.5 years
($2.75 million/ 27.5 years = $100,000).
For those that don’t want to wait 27.5 years to benefit, the IRS allows you to front load or accelerate the depreciation using a cost segregation study.
This allows items to be depreciated over shorter time schedules of 5, 7, and 15 years by identifying all of the non-structural elements of the property along with any land improvements.
This creates larger paper losses in the early years of ownership.
That accelerated depreciation has the effect of giving the investor more depreciation benefit in the early years of ownership.
This is great as most of us passive investors are investing in deals with a 5-7 year hold time.
What Is Bonus Depreciation?
Bonus depreciation is a form of accelerated depreciation that allows you to take the benefit in the FIRST year instead of over the 5,7 or 15 year schedule.
The Tax Cuts and Jobs Act in 2017 was passed that stated if property was or is purchased after September 27, 2017, and before January 1, 2023 then you can get a first year 100% benefit.
Unfortunately, this benefit is going to get phased out by 20% each year through 2027.
What Is Depreciation Recapture?
Depreciation offers real estate investors a way to reduce taxes at their ordinary income tax rate. It also helps to reduce the property’s cost basis which determines the loss or gain during the sale.
If the property is held for at least a year, long-term capital gains tax is paid which is currently between 0-20% depending on your income.
However, not all gains benefit from the long-term capital gain tax rates.
It’s something called deprecation recapture implemented by the IRS to “recapture” the taxes you would have paid over the years without the benefit of claiming depreciation.
The depreciation recapture rate on this portion of the gain is 25%.
The reasoning the IRS came up with this is that since the taxpayer received the benefit of a deduction that offset ordinary income tax rates (close to 40% for most high-income earners), the government is not going to grant the more favorable capital gains rates (0-20%) on the portion of the gain relating to these prior depreciation deductions.
They do all they can to take as much as they can from you. It’s for this reason that basic tax knowledge needs to be learned and updated to stay on top of never having to pay a penny more that’s owed.
Depreciation Recapture Example
Dr. B purchases an apartment complex in his hometown for $2 million (excluding land) and takes $500,000 of depreciation deductions over the first ten years of ownership.
At this point, his basis in the complex is $1.5 million.
$2 million – $500K in deductions = $1.5 million
His two sons decide to go to medical school which encourages him to sell the building to help with their education costs.
Luckily, he finds a buyer that agrees to pay him $5 million which gives him a gain of $3.5 million.
($5 million – $1.5 million).
Dr. B presumed the $3.5 million would be taxed at a capital gain rate of 20%. However, in this example, his real estate CPA informs him that $500,000 of the gain (amount depreciated) would be taxed at the recapture rate of 25%.
The remaining $3 million gain would be taxed at the 20% capital gain rate. Dr. B is thankful that he had some cash saved as he owes an additional $25,000 in taxes (5% on $500,000) on the sale of his asset.
What if the gain is less than the previous depreciation deduction?
Depreciation recapture is limited to the lesser of the gain or, the depreciation previously taken.
For example, if Dr. B would have sold the building for only $1.6 million, his gain would have been $100,000 ($1.6 million – $1.5 million).
Because the $100,000 gain is less than the depreciation deductions ($500,000), the 25% recapture rate would apply to the entire $100,000 gain.
What if the property sells for a loss?
The depreciation recapture rules do not apply if the property ends up selling for a loss.
If Dr. B could only get $1 million for his apartment complex then he would simply report a loss of $500,000.
No depreciation recapture calculations would be required.
The 25% depreciation recapture tax rate only applies to the portion of the gain attributable to real property.
If a sales contract includes the sale of other assets, such as equipment and furniture, the gain relating to depreciation recapture on those assets would be taxed at the property owner’s ordinary income tax rates instead.
Can You Avoid Depreciation Recapture Taxes?
There are a couple of ways that you can avoid depreciation recapture taxes. We just discussed one of the ways by selling at or below the depreciated value which makes there no depreciation to recapture.
Another way to delay the depreciation recapture taxes is by rolling the proceeds of the sale of your property into another one within 180 days using a 1031 exchange.
*Disclaimer: I’m a periodontist and NOT a CPA. I’ll do my best to provide you with education regarding taxes, bonus depreciation and how bonus depreciation recapture works. Consult with your CPA or tax attorney before implementing anything mentioned here.Join the Passive Investors Circle