Introduction
Investing in real estate, especially commercial real estate, is a profitable venture and one that creates more millionaires than any other endeavor. Something incredibly important to understand when considering investing in real estate are the tax implications. One crucial and overlooked aspect of real estate taxation is depreciation recapture. In this blog post, we will explore what depreciation recapture is, how it can occur when selling investment real estate, and why 1031 exchanges, combined with tenant-in-common (TIC) properties, can be a valuable solution for investors looking to defer their tax liabilities effectively and legally.
What Is Depreciation Recapture?
Depreciation is a tax benefit that allows real estate investors and landlords to deduct a portion of the improved value of their property for a set period of time, like 27.5 years for a residential investment. This deduction helps offset rental income, thereby reducing the investor’s taxable income. However, the IRS does not want investors to enjoy this tax benefit indefinitely—when the property is eventually sold, the IRS requires investors to recapture or “pay back” the tax benefits they previously claimed through depreciation.
Here’s how depreciation recapture works:
Depreciation Deductions: During the ownership of an investment property, the property owner can claim depreciation deductions on their tax returns, reducing their taxable income.
Calculating Recapture: When the property is sold, the IRS requires the property owner to recapture the accumulated depreciation, or what should have been depreciated. The recaptured depreciation is taxed at 25%, regardless of tax bracket, rather than as a capital gain.
Tax Consequences: The tax rate on recaptured depreciation can be significantly higher than the capital gains tax rate. This can result in a substantial tax liability for investors who are unprepared for depreciation recapture.
How Does Depreciation Recapture Occur?
Depreciation recapture typically occurs when an investor sells an investment property. The adjusted basis includes the original purchase price, plus any capital improvements made over the years, minus accumulated depreciation.
Let’s illustrate this with a real-world example:
Imagine you purchased an investment property for $300,000 and claimed $50,000 in depreciation deductions over the years. If you sell the property for $400,000, your adjusted basis would be $300,000 (purchase price) – $50,000 (accumulated depreciation) = $250,000.
Since you’re selling the property for $400,000, there is a gain of $150,000 ($400,000 – $250,000 = $150,000). This $150,000 gain is subject to depreciation recapture at a tax rate of 25%, regardless of the tax rate with which the deduction was taken.
The Solution: 1031 Exchange
While depreciation recapture can result in a significant tax hit for investors, there is a legal and powerful solution available: the 1031 exchange.
A 1031 exchange allows real estate investors to defer the payment of capital gains taxes, including depreciation recapture, and other taxes, by reinvesting the proceeds from the sale of one investment property into another like-kind property. By utilizing a 1031 exchange, investors can continue to grow their real estate portfolio while deferring the tax liability associated with depreciation recapture.
The Advantages of 1031 Exchanges with TIC Properties
Here’s where Millcreek Commercial comes into play, offering a unique and advantageous approach to 1031 exchanges through tenant-in-common (TIC) ownership:
We offer TIC properties all over the country. We always have properties available for your immediate identification. The best part: since we offer these properties debt-free in the form of a TIC, we can match your investment to the penny. What does this mean?
We help investors and landlords nationwide find replacement properties that precisely match their investment amount. This ensures that they can reinvest the full proceeds from their sold property without incurring additional tax liability—which is referred to as “boot”.
For example, let’s say that you sold an apartment complex for $1,500,000. When looking for potential replacement properties, you are having a difficult time finding something for that exact amount, meaning you will either have to pay taxes on the boot, or gather extra funds to meet the greater purchase amount.
When investing with Millcreek Commercial in a TIC property, we can take your $1,500,000 and put it into a NNN leased building, meaning you will receive a return on your investment immediately, and according to the percentage of the building you own. For greater diversification, we can even take $700,000 and put it into a healthcare center in Georgia, $300,000 into a retail store in Alabama, and $500,000 into a daycare center in Illinois. This helps you reduce risk and potentially increases your income potential with differing cap rates. (View our inventory here)
As we mentioned before, we have properties with NNN leases. A NNN lease means that the owner of the real estate is not responsible for the day-to-day operations of the property; no maintenance, repairs, or late-night calls are required on your end. These types of properties offer you true passive income. By combining the power of a 1031 exchange with TIC ownership, you can effectively defer depreciation recapture and capital gains taxes, enabling your investments to grow unhindered by tax burdens, all while gaining a passive lifestyle—it’s a no brainer!
Conclusion
Depreciation recapture is a tax liability that every real estate investor needs to be aware of and understand when selling investment properties. One needs to be fully prepared for it, because failure to plan can result in substantial tax bills that reduce your investment gains. However, with proper tax planning and the use of 1031 exchanges, you can defer these tax liabilities and continue to build wealth in the real estate market.
Millcreek Commercial offers a unique and advantageous solution through tenant-in-common (TIC) ownership, ensuring that your 1031 exchange funds are matched precisely to your investment amount. This approach allows you to effectively manage depreciation recapture and build a diversified, income-generating real estate portfolio. Contact a member of our team today to discuss your investment options.
