DST Depreciation Recapture: What You Need to Know Before Investing
Carl E. Sera, CMT
June 21, 2023
The Impact Of Depreciation Recapture On DST 1031 Exchanges
Depreciation is an essential component of the non-recognition provisions of IRC 1031 rules because it is an integral part of calculating the adjusted basis of the property. While deferring capital gains taxes is frequently in the news, depreciation recapture costs can skyrocket. A good 1031 exchange results in tax deferral for both taxes. However, depreciation recapture deferrals are more nuanced than gains.
We'll review how depreciation recapture is calculated and deferred in a DST 1031 Exchange with you as the exchanger. Finally, we'll show how these taxes can ultimately be avoided entirely.
What Is Depreciation Recapture?
The accumulated depreciation is “recaptured” when a property is sold and classified as taxable income. Real estate is an asset whose physical condition degrades over time. For example, HVAC systems can wear out, or the constant wear and tear of commercial use can ruin carpet, paint, and other finishes. To account for degradation to the property, the IRS allows investment property owners to expense a portion of the asset’s value each year in a process known as depreciation.
On a year-to-year basis, the expense of depreciation reduces the property’s tax liability. But, this same depreciation “accumulates” over a multi-year period, and the resulting reduction in a property’s “tax basis” usually means a big difference between the tax basis and the sale price. This is where depreciation recapture comes into play.
When a property is sold, the depreciation accumulated over its holding period is “recaptured” and taxed. For investors who aren’t prepared, the tax bill can come as a big surprise.
Calculating Depreciation Recapture
The first step in calculating your depreciation recapture for an asset is to determine its cost basis; this includes the price paid for the property and any closing costs paid by the buyer. Then determine the adjusted cost basis by subtracting any deductions made since you’ve owned the asset, such as the cost of improvements made to the property. To determine the depreciation recapture, subtract the adjusted cost basis from the sale price for the asset.
For example, an investor purchases a property for $1,000,000. Over five years, they take $250,000 in depreciation, which means the adjusted basis is $750,000 ($1,000,000 – $250,000).
The $250,000 portion of the gain is depreciation being recaptured and excluded from favorable long-term capital gains tax rates. Not that complicated yet, but there’s more to consider in computing depreciation recapture taxes.
However, two scenarios may play out when finding the impact of depreciation recapture on DST 1031 Exchanges.
Scenario #1: Capital gains are more than accumulated depreciation
The difference between the sales price and the adjusted basis is a taxable gain, and it is treated differently than the taxes on depreciation recapture. Suppose that the above property sold for $1,260,000. This means that there is a gain of $510,000, which is more than the total accumulated depreciation of $250,000.
Depreciation recapture is taxed as ordinary income and is one of the highest tax rates associated with selling real estate, a depreciable asset. Depreciation Recapture Tax is 25% across the board, only second to real estate owned less than one year, taxed as ordinary income, which could be as high as 37%. Assuming the standard capped 25% depreciation recapture tax, the tax due on the $250,000 depreciation recapture in the above example is $62,500 ($250,000 * 25%).
Long-term capital gains for properties held for more than one year are taxed lower than depreciation. As of this writing, the top capital gains tax rate is 20%. Because the remaining gain is $260,000, the investor would owe $260,000 multiplied by 20% or $52,000 in capital gains taxes. In this scenario, the total tax bill is $114,500 (please note, this shows federal and depreciation recapture - state and net investment income taxes are not included in this example).
Scenario #2: Capital gains are less than accumulated depreciation
Now, assume the same $1,000,000 purchase price and $250,000 in accumulated depreciation. But, in this scenario, assume a sales price of $490,000, which results in a loss of $260,000 ($490,000 sales price minus $750,000 cost basis).
Because the loss of $260,000 is more than the accumulated depreciation of $250,000, there is no depreciation recapture tax. In addition, the taxpayer would not be required to pay capital gains taxes because the property sold for less than its adjusted basis. The loss creates three options with regard to the filing of the tax return:
It can be used to offset tax liabilities in the current year,
It can be “carried back” to reduce taxes in the previous two years, or
It can be “carried forward” to reduce tax liabilities in future years.
In scenario #1, the taxes due can be deferred by entering into a 1031 Exchange transaction.
Scenario #3: When selling with a capital gains loss
Depreciation recapture will not apply to losses. Say you sell for $500,000 in the previous example. You would report a loss of $250,000 ($750,000 adjusted cost basis minus the $500,000 sale price). While this is a big loss, you did benefit from $250,000 in depreciation expenses over the past five years. It could be considered a wash in that regard.
Except, the $250,000 is considered a §1231 loss. This means it can be used –
to reduce your tax liability during the current tax year,
as a carried-back offsetting income from the previous two years, or
carried forward to offset future income.
A §1231 loss–not applied against a net §1231 gain–is an unrecaptured loss. These losses will be applied against net §1231 gain beginning with the earliest loss in the five years.
How Can I Avoid or Defer Depreciation Recapture?
If you want to minimize your tax burden, a 1031 exchange – named for IRS Section 1031 of the IRS’s tax code – can help you defer depreciation recapture and capital gains taxes. Under the terms of a 1031 exchange, however, you must utilize the sale proceeds to invest in another investment property.
Put simply, as a seller, you can delay any capital gains taxes on the sale of your investments by selling a property and putting proceeds to work toward a property similar to the one sold and of equal or greater value to your original holding. In practice, you gain no profit from the sale of your property when ownership is transferred to a new purchaser but can apply any sums earned toward increasing your overall real estate investment portfolio.
Final Thoughts
Depreciation helps reduce taxation if you’re a rental property owner or real estate investor. At the same time, there are limitations on how much you can deduct from your taxes and use to reduce the amount of money you owe to the IRS in any given year. Regardless, with some careful upfront financial and tax planning, and an eye toward rolling profits into the growth of your real estate portfolio, you can make your money go much further.
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