Selling real estate can potentially provide a significant return on investment. When considering whether to sell a property, investors often examine tax considerations, potential resale value, and market conditions. Depreciation recapture is one practice of the Internal Revenue Service (IRS) that can significantly impact an investor’s profit when they sell a property.
With depreciation recapture, the IRS collects unpaid income taxes on a property when the owner sells it. Understanding this practice and the applicable depreciation recapture tax rate can help investors plan for and even defer depreciation recapture taxes.
Read on or skip to a specific section:
- What Is Depreciation Recapture?
- When Do You Have to Account for Depreciation Recapture?
- How to Calculate Depreciation Recapture
- How Depreciation Recapture Works
- Examples of Depreciation Recapture
- Planning for Depreciation Recapture
- Can I Avoid Depreciation Recapture?
What Is Depreciation Recapture?
Depreciation recapture is when the IRS collects taxes on capital assets that an individual sells for a gain that they previously wrote off as a tax deduction. Many kinds of real estate and other property are depreciable for tax purposes, meaning the owner can divide the cost over its useful life and take tax deductions on that amount. Although depreciation is legal and common, the IRS counts any profit from selling such properties as Section 1231 Gains and Losses, which are subject to depreciation recapture.
All capital assets depreciate at different rates, and real estate can even appreciate over several years. If an individual takes depreciation deductions on a real estate property and then sells it for a profit because it appreciated, they would essentially gain the benefits of depreciation deductions and the most favorable capital gains rates. Therefore the IRS recaptures the depreciation to ensure the owner pays taxes on the property.
When Do You Have to Account for Depreciation Recapture?
Depreciation recapture applies when a property owner sells or disposes of depreciable property at a profit. For an individual to depreciate their real estate or rental property, they must meet specific IRS criteria:
- The individual must own the real property.
- The individual must use the real property in their business or another income-producing enterprise.
- The real property must be expected to last longer than one year.
- The real property must have a determinable useful life.
If all these requirements are met, the property owner can take depreciation deductions for their property. Real estate depreciates over a specific period depending on its classification. For residential rental properties, this period is 27.5 years, and for nonresidential real properties, the period is 39 years.
Many real estate properties appreciate over time, regardless of their classification. Through appreciation and depreciation deductions, the sale or disposition of the property might result in a profit and a capital gain for the owner.
When an individual takes depreciation deductions on their property and then sells it for a gain, they must account for depreciation recapture when they sell the property. The IRS does not recapture the depreciation when an individual sells their property for a loss.
How to Calculate Depreciation Recapture
Real estate investors and property owners may be interested in calculating depreciation recapture before they sell a property. Determining how much they will owe the IRS for depreciation recapture can help property owners choose the best way to maximize their wealth.
1. Determine Your Property’s Cost Basis
An asset’s cost basis is the amount the owner spent to purchase it. This figure is essentially the amount the property’s owner has invested in buying the asset. To verify a piece of real estate’s cost basis, determine its total cost, including sales tax.
2. Calculate Adjusted Cost Basis
Specific events that occur when an individual owns an asset can affect their basis in the asset, resulting in an adjusted cost basis. Property owners need to figure their asset’s adjusted cost basis when determining depreciation recapture.
To calculate an asset’s adjusted cost basis, add the fees and commissions paid during the sale, then determine how much you spent on capital improvements to the property. Capital improvements can include expenditures to better, restore, or adapt the property to a different use.
The tax deductions portion of the adjusted cost basis is the amount the owner deducted from their taxes for the property. This amount includes allowable depreciation deductions and insurance reimbursements for losses.
3. Figure Capital Gain or Loss
The next step in determining depreciation recapture value is calculating whether the sale of the property results in a capital gain or loss. Depreciation recapture only applies if the property owner sells the property for a net gain. It is essential to remember that capital gains are based on the adjusted cost basis rather than the original cost basis.
An individual subtracts the property’s adjusted cost basis from the sale price to determine whether they made a capital gain. The IRS taxes capital gains depending on how long the owner holds the property, which can be long-term — more than one year — or short-term.
4. Determine Depreciation Recapture Value
Once you calculate whether the sale of your property is a net gain or loss, you can determine its depreciation recapture value. To calculate a property’s depreciation recapture value, subtract the adjusted cost basis from the original cost basis. The resulting figure is the amount the IRS will tax you to recapture depreciation. If the sale of the property results in a net loss, the IRS will not recapture the depreciation.
The IRS taxes short-term gains as ordinary income and long-term gains at the capital gains tax rate, which is between 0% and 20%, depending on the owner’s income bracket. The depreciation recapture tax rate for Section 1250 property is currently capped at 25%.
How Depreciation Recapture Works
Depreciation recapture can significantly impact property owners’ tax burden if they sell real estate. Property owners can plan for this process by understanding how depreciation recapture works and how it could affect the sale of their property.
1. An Individual Purchases Property
The IRS recaptures the depreciation from two types of assets — properties defined in Section 1245 of the IRS Tax Code and properties defined in Section 1250. Assets in these categories must meet specific criteria. Any gains from the sale of these assets are subject to different tax regulations.
Section 1245 of the IRS Tax Code covers a wide variety of assets, while Section 1250 relates to real estate property. Only personal, tangible property, except buildings and their structural components, are subject to the regulations of Section 1245 of the IRS Tax Code. Section 1250 outlines depreciation recapture of all real estate property.
If an individual purchases real estate, it will be subject to Section 1250 of the IRS Tax Code. The IRS will use the asset’s cost basis to determine the adjusted cost basis and depreciation recapture when the owner sells the property.
2. Assets Depreciate
Over time, the individual can take depreciation tax deductions on their real estate. The IRS has nine property classifications into which assets can fall, although real estate will either be categorized as a residential rental property or nonresidential real property.
Real estate depreciates as soon as the owner places the property in service. Many property owners use the straight line method to deduct the same amount from their taxes every year. Even if the property owner never takes deductions for depreciation, the IRS still counts all allowed and allowable depreciation.
3. The Property Owner Sells the Real Estate
When the property owner decides to sell their real estate, the property has likely appreciated. If the sale of a real estate property results in a net gain for the owner, the IRS will recapture the depreciation deductions the individual took during the period they owned the property.
4. The IRS Recaptures the Depreciation
The IRS taxes the part of an individual’s gains that comes from depreciation deductions at the higher depreciation recapture tax rate of 25%. The rest of the profits might qualify for long-term capital gains tax rates, which have a maximum rate of 20%.
The IRS also taxes various kinds of assets differently. The gain from the sale of Section 1245 properties that the IRS treats as ordinary income is the lesser of these two amounts:
- The property’s allowed and allowable depreciation
- The gain from the sale minus the property’s adjusted basis
Any gains from the sale of a Section 1250 property may be taxed as ordinary income at the capital gains tax rate according to the owner’s tax bracket, based on the lesser between:
- The difference between the sales price and the adjusted basis of the property
- The depreciation deductions the owner took
Otherwise, these gains are subject to the 25% maximum depreciation recapture tax rate.
Examples of Depreciation Recapture
The depreciation recapture amount from the sale of real estate property can depend on several factors. An example of the depreciation recapture of a Section 1250 property may help property owners understand this process.
Suppose an individual buys a property for $2 million and takes $500,000 in deductions over 10 years. The adjusted basis for the property is now $1.5 million. If the owner sells the property for $5 million, their capital gains are $3.5 million.
The IRS will not tax all of the gains at the more favorable capital gains tax rate. Instead, depreciation recapture is based on the portion of the gain owing to the depreciation deductions the owner took over the time they owned the property. Of the property owner’s profit, $500,000 will be taxed according to the depreciation recapture tax rate of 25%. The IRS will tax the remaining $3 million at the capital gains rate that applies to the owner’s tax bracket.
Planning for Depreciation Recapture
Because depreciation recapture can significantly impact an individual’s tax burden, many real estate investors and property owners try to plan ahead to navigate the process. While there are limited ways to get around paying depreciation recapture taxes on gains from the sale of qualifying properties, many rental property owners may be able to deduct passive activity losses, which can offset the cost of depreciation recapture.
Passive activity losses are losses that occur when an individual generates passive income without materially participating. Rental and rental real estate activities count as passive activities even if the property owner does materially participate, though not if they qualify as a real estate professional. However, other investors and property owners may be able to take advantage.
If a rental property owner experiences passive activity losses, they can deduct them when selling the rental property. In previous years, this action was not allowed. This deduction may lessen the tax burden of depreciation recapture. However, property owners can only take the deduction because they experienced a loss upon selling their property.
When planning for depreciation recapture, many property owners decide to take the maximum depreciation deductions. The IRS will require depreciation recapture taxes whether property owners take the deductions or not. Taking deductions can also lower an individual’s taxable income enough to reduce their tax liability for the year significantly. Because capital gains tax is determined based on an individual’s tax bracket, taking deductions could reduce a property owner’s capital gains tax burden.
Can I Avoid Depreciation Recapture?
Another option for navigating and avoiding depreciation recapture is the 1031 exchange. Named for the section of the IRS Tax Code that describes them, 1031 exchanges are procedures in which property owners sell a property and use the proceeds to purchase a like-kind property to defer capital gains tax. These kinds of property exchanges can be helpful for individuals looking to avoid depreciation recapture because they also defer depreciation recapture taxes.
A 1031 exchange requires the property owner to retain a qualified intermediary to hold the proceeds of the sale and purchase a replacement property on behalf of the property buyer. After one 1031 exchange, sellers can perform another exchange after holding the property for at least two years or sell the property immediately without an exchange. Without an exchange, they will have to pay all deferred capital gains and depreciation recapture taxes.
While a 1031 exchange doesn’t erase the responsibility to pay for depreciation recapture, investors can defer the depreciation recapture tax until later. Property owners may also perform 1031 exchanges until they pass away and leave the property to an heir. In this case, the property’s cost basis is stepped up, and the heir pays no capital gains or depreciation recapture tax. A 1031 exchange allows real estate investors to build more substantial portfolios than if they were paying the tax after each property sale.
What Happens to Depreciation Recapture in a 1031 Exchange?
Depreciation recapture can significantly increase a property owner’s tax burden upon selling real estate. Many real estate investors and rental property owners can benefit from strategies to reduce the tax impact when they sell their property. Performing a 1031 exchange may be able to help with depreciation recapture. When property owners complete a 1031 exchange, they can defer depreciation recapture taxes and increase their cash flow.
Learn More About How to Use a 1031 Exchange to Avoid Depreciation Recapture
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If you are interested in 1031 exchanges, register with 1031 Crowdfunding to view properties on the exchange.
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