In this article, we discuss depreciation recapture tax, what it is, how it will affect the sale of your rental, and how to avoid it. If you are looking to sell a property in the future and would like to avoid depreciation recapture tax and all capital gains tax, view our current inventory here. To talk directly to a 1031 exchange expert today, give us a call: 385.248.0613

If you’re an experienced rental property owner who benefited from depreciation, be aware that the IRS might want some of that money back when you sell. Depreciation is one of the most significant and most advantageous deductions for real estate investors because it reduces taxable income but doesn’t reduce your cash flow—a magical tax deduction. The IRS allows real estate investors to depreciate their investment property over a period of time, 27.5 years for residential rental investments saving landlord thousands of dollars in taxes every year.

This is the part of the article where we tell you that we are not professional accountants, CPAs, or attorneys. Any information that you garner from this article should be discussed with your accountant or other professionals.

As an investment real estate owner, you and your accountant have likely become very familiar with this deduction. The IRS allows this tax deduction because, in theory, improvements have a useful life span and lose value over time. Take for example, an automobile. The IRS allows a business to depreciate an automobile over seven years. When the company trades that vehicle back into the dealer in three years, it has lost over half of the original value. If the owner has depreciated 40% of the cost on the prior year’s tax returns, they write off the final 10% when they trade it in. Thus, depreciation makes sense in such a case. However, real estate often (in fact, almost always) increases in value. 

IRS tax code allows investors to depreciate the improvements (buildings, etc.) related to real estate. However, if you sell your real estate investment after 20 years and the property has increased in value, the IRS wants their money back and will assess you at a 25% tax rate on the amount you have previously deducted. For many investors who hold their real estate for an extended period, the depreciation recapture tax can be much more onerous than the capital gains tax (15%–20%).

How does depreciation recapture work on a rental property?

At some point, you may decide to sell your rental property. Depreciation will play a role in the amount of taxes you’ll owe when you sell. Because depreciation expenses lower your cost basis in the property, they ultimately determine your gain or loss when you sell. The IRS will demand that you pay a premium on that portion of your gain.

If you hold the property for at least a year and sell it for a profit, you’ll pay long-term capital gains taxes. If you’re a higher-income taxpayer, you may also be on the hook for a 3.8% net investment income tax – NIIT. Additionally, you will likely encounter the devil of all taxes–depreciation recapture.

The IRS remembers all those depreciation deductions, and they’ll want some of that money back. That’s what depreciation recapture does. The rate is based on your ordinary income tax rate and is capped at 25%. It applies to the portion of the gain attributable to the depreciation deductions you’ve already taken. Because the sale of your property likely pushes you into a higher tax bracket for the year of the transaction, it is almost always 25%.

Let’s say you purchased a rental property ten years ago for $200,000. You should have written off about $54,540 in depreciation deductions over those ten years. Your adjusted cost basis in this property after the ten years is $95,460 (the original cost basis of $150,000 minus $54,540). If you can sell the property for $280,000, you will recognize a gain of $184,540 ($280,000 minus $95,460).

While it would be nice to pay taxes at the lower capital gains rate on the entire gain, you’ll pay up to 25% on the part that is tied to depreciation deductions. If you owe the maximum, it would be 25% of $54,540, or $13,635. 

The remaining $130,000 is taxed at your regular long-term capital gains tax rate. Assuming you’re in the top bracket, that would be $26,000 in capital gains taxes. With just these two taxes, you’re looking at $39,635 in taxes. Also, you may owe the NIIT, and your state will likely want a piece of the action as well. 

Depreciation recapture can be the most painful “stupid tax” known to humankind. Tax code requires that the IRS assumes you took the depreciation, even if you did not take the deduction. Therefore, if you have been doing your taxes for years and have not been taking advantage of depreciation when you sell your property, the IRS will assume that you have taken the deduction. They will then assess the tax on what you should have taken – even if you never benefited from the deduction.

How can I avoid paying tax on my depreciation deductions?

If you own investment real estate and are looking to sell, you’ll want to become very familiar with the pending tax liability and potential strategies to defer these taxes. Many investors consider taking advantage of Section 1031 of the IRS tax code. Commonly referred to as a 1031 exchange, this section allows investors to defer paying taxes when they sell investment real estate and reinvest the proceeds from the sale in investment real estate of equal or greater value. Taxes that need to be paid on depreciation recapture, federal capital gains, state taxes, and NIIT are all deferred. Effective use of a 1031 strategy allows investors to create, store, and transfer wealth tax-free. It would be best if you planned in advance to take advantage of this deferment strategy. You should always contact a 1031 exchange specialist (qualified intermediary) before selling your current property.

Millcreek Commercial specializes in 1031 exchange strategies. Exchanging residential rental properties for other rental properties is often a net-zero trade–one set of headaches for another. However, exchanging residential rental properties for high quality, NNN leased commercial real estate can bring the safety, security, and stability your portfolio deserves. Many investors fill the role of landlord. With that title comes several things that contribute to headaches–tenants moving in and out, fixing toilets, painting walls, replacing carpet, and the list goes on. By exchanging into NNN leased commercial real estate, maintenance, improvements, and property taxes, all headaches are essentially the tenants’ responsibility. This powerful lease structure creates a true form of passive income. Learn more about how 1031 exchanges and NNN lease properties can be your “x-factor” for retirement in this blog post.

If you are looking to sell a property in the future and are interested in deferring taxes and creating passive income, please give us a call. Our investment team would love to speak with you. 385.248.0613

Want to learn more about 1031 exchanges and the benefits, rules, and risks? Download our FREE ebook — a comprehensive guide to 1031 exchanges. 

Always consult a qualified tax professional and 1031 exchange expert.

Keep in mind that these examples are overly simplified. Also, rental property tax laws are complicated and change periodically. Unless you’re a real estate tax pro, you should work with someone who is.