Understanding Depreciation Recapture on the Sale of Property
Carl E. Sera, CMT
October 15, 2020
Owning a real estate property comes with a lot of benefits. But if you are like most property owners in the US, chances are you have little to no idea on the amount of taxes you may be responsible for upon the sale of the property. From state taxes to federal taxes, the list is numerous.
In this article, we will reveal a whole new level of tax unfamiliar with most property owners looking to sell their home. You will learn about Depreciation, the Depreciation Recapture Tax, and how you can avoid it upon the sale of your property.
What is Depreciation in Real Estate?
The IRS defines depreciation as a capital expense that is the mechanism for recovering your costs in an income-producing property, and must be taken over the expected life of the property. It allows you to deduct the cost of buying and improving a property over its useful life. Depreciation is one of the benefits of owning real estate for most real estate investors.
This is because it allows you to reduce your taxable income without any reduction in your cash flow. When you acquire a real estate property, the IRS allows you to deduct depreciation over 27.5 years if it is an investment property, and 39 years if it is a non-residential property using the straight-line tax method.
Let’s use a simple example to drive home the above explanation. Let’s say you purchased a residential duplex for $450,000 on January 1st.
To calculate your depreciation amount:
- The Cost Basis (Purchase Price) deducted by the land value will equal the building value.
- The building value divided by 27.5 will give you your annual depreciation deduction.
So if the value of the land on which the duplex sits is $45,000, the calculation would look like this:
- $450,000 deducted by $45,000 equals $405,000 for the building value
- $405,000 divided by 27.5 years equals $14,727 approximately.
Your allowed annual depreciation is $14,727. The IRS tax code on depreciation allows you to deduct depreciations on the improvements (i.e. the building and not the land). However, if you sell the property for a gain, the IRS requires that you pay back a percentage of the depreciation you have deducted over the years. This is known as Depreciation Recapture Tax.
What is Depreciation Recapture Tax?
Since most real estate property owners can deduct depreciation over the useful life period (27.7 years) of their property, the IRS introduced what is now known as Depreciation Recapture or the IRS Section 1250. When you deduct these depreciations over the years, the IRS considers it as a gain on your part since it reduces your cost basis and taxable income.
So, upon the final sale of the property, the IRS requires that you refund a certain percentage of the depreciation deductions you have received over the years the property was in service. To make it clearer, we will use the following example to explain the whole theory of depreciation recapture.
- You acquired a duplex for $450,000 but since you need to subtract the cost of the lot, you are left with a building value of $405,000.
- You deduct depreciation of $14,727 each year, for 12 years. The total depreciation deducted is $176,724
- Your adjusted cost basis for the duplex is now $228,276 (To get the adjusted cost basis, you subtract the total depreciation from the building value)
- After 12 years of holding the property, you decide to sell the property for $600,000, and your realized gain is $371,724
- Since you realized a gain upon the sale of the duplex, the IRS will require that you pay up to 25% on the part of the gains tied to your total depreciation deductions. So, if your ordinary-income rate is capped at 25%, then it would be ($176,724*.25) which equals a depreciation recapture of $44,181
- The remaining portion of the gains realized will be taxed at the long-term capital gain tax rate by the IRS. If your capital gains tax bracket is at the highest (i.e. 20%), then your capital gains tax would be ($195,000*.20) which equals a capital gains tax of $39,000.
So, upon the sale of the duplex, you may need to pay the IRS $83,181 in taxes. When filing your tax, you will need to report your depreciation recapture on IRS Form 4797. Please consult a professional tax advisor for assistance with your specific situation.
Avoiding Depreciation Recapture Tax by Doing a 1031 Exchange
Generally, when you sell a real estate property for a gain, the IRS requires that you pay back depreciation recaptures taxes and capital gain taxes on the realized gains. However, you can avoid or defer paying these taxes by doing a 1031 exchange.
The IRS tax code 1031, allows you to defer the payment of taxes by reinvesting the entire sale proceeds plus the gains into the purchase of another property while abiding by IRS-stipulated guidelines.
Using our earlier duplex examples:
|Taxable Sale||1031 Exchange|
|Federal Tax Liability||$83,181||$0|
If you look at the table above closely, you’d notice that the investor will need to pay the IRS $83,181 in taxes. But on the 1031 exchange side, the taxes are zero. The investor was able to defer the payment of all forms of taxes by simply doing a 1031 exchange. So, if your goal is to ‘avoid’ the payment of depreciation recapture taxes, then doing a 1031 exchange is your best bet.
If you're interested in learning how to do a 1031 Exchange and want to learn more about Depreciation Recapture and Depreciation Recapture Tax, read our article on 1031 Exchanges and Delaware Statutory Trusts