If you own or manage a rental property, chances are that you’ve heard of depreciation before. Once you’ve determined your depreciation rates, expensing it year-after-year can be pretty straightforward. However, if you decide to sell your property, any depreciation that you’ve taken will come back to you as a depreciation recapture. While the concept of depreciation recapture is more complicated than depreciation expense, real estate investors will benefit from understanding how depreciation recapture will affect your tax liability to avoid surprises when it comes time to file your tax returns.
In the eyes of the IRS, the concept of depreciation consists of three factors: (1) the costs of incoming-producing property, (2) the useful life, or recovery period, of the property, and (3) the depreciation method used. Simply put, when rental owners buy property, i.e. building, equipment or furniture, to be used in their rental activities, the cost of these items get expensed over the expected useful life of the property, instead of getting expensed all in the year the property was purchased. Let’s take a simple example, I buy a residential property on January 1 for $100,000 and determined that the building is valued at $75,000 and land is valued at $25,000. I calculate depreciation on the building over the IRS useful life of 27.5 years (keep in mind that land is not depreciable), so every year the depreciation I can expense is $2,727.27 ($75,000 ÷ 27.5) for the next 27.5 years. Once the building is fully depreciated, there is no more deduction allowed as I’ve now taken the full deduction on my initial investment of the building.
One key factor for real estate investors to keep in mind is that depreciation reduces your taxable income every year, but it also reduces your basis in the property for figuring gain or loss if you were to sell the property. This is where depreciation recapture comes into play.
Typically a gain on property qualifies for preferential capital gain tax rates if it has been held for over one year. This is not the case for the portion of the sale that represents depreciation recapture, that being the amount of depreciation that you’ve taken on the property through the time of sale. Instead, the portion that represents depreciation recapture is taxed as ordinary income at the taxpayer’s marginal tax rate for non-real estate property. For real property, any depreciation recapture is given a separate tax rate known as the unrecaptured Section 1250 gain rate which is capped at 25% for 2019. In both instances, any portion of the gain over the depreciation recapture amount will still receive capital gain rates as long as the property has been held for over one year.
Things to Consider
There are strategies that real estate investors can consider before they sell their property to help reduce their tax liability, however, because every circumstance is different we recommend speaking to a financial planner or CPA before you get started.
As always, our CPAs at Mason + Rich are ready to answer any additional questions. Feel free to call us at 603-224-2000.