What is recapture of depreciation and how can I avoid it?

If you use property as a business resource, you expect it to have a useful life and eventually decline in value due to wear and tear from regular use. The IRS allows you to deduct the cost of the loss of value equally over the life of the property on your taxes, referred to as depreciation. However, if you then end up selling that property for profit, there’s recapture of depreciation, so that you don’t benefit both when you use the property and when you sell it.

This article is intended to give you general information on depreciation recapture to understand it and ways of limiting your tax liability. It’s not intended to be personalized tax advice. For information on your personal situation, we recommend speaking to a financial planner or tax preparer.

Key Takeaways:

• Depreciation accounts for the fact that business property tends to wear down over time and lose value. However, if you sell it for a profit, depreciation is recaptured at ordinary income tax rates.
• After depreciation recapture, regular capital gains tax rates apply.
• You can’t fully avoid depreciation recapture, but you can delay this and capital gains taxes through 1031 exchanges. You put the money from the sale back into another investment property.

What is depreciation recapture?

Depreciation recapture (or “recaptured depreciation”) refers to an IRS policy that if you’ve taken depreciation on business property over its useful life to account for the loss in value over time, if you then sell the asset for a profit, the IRS can take back – or “recapture” – that depreciation.

This is done by taxing your profits at ordinary income tax rates, up to the amount of depreciation taken over the years. Beyond that, the profits would be taxed at capital gains tax rates, which are often lower depending on your income tax bracket.

What is depreciation?

Depreciation is the extent to which property that you have loses its value over the time that you use it. You often hear about this if you buy cars, but depreciation applies to anything that wears out over time.

The reason this matters is that business owners can deduct from their taxes an amount equivalent to what they paid divided by the useful life of the property. As a business asset, investment properties are depreciable.

There are a couple of different methods you can use to determine the amount of yearly depreciation. Generally, you use a general depreciation system where the useful life of residential rental property is 27.5 years. Some may be required or allowed to use the alternative depreciation system which puts the useful life of the property at 30 years.

Depreciation recapture, explained

While you can take depreciation on the theory that assets lose value over their life, depreciation recapture accounts for the fact that not everything depreciates in the way we expect. If you buy something as a business asset and take depreciation on it – be it a car, computer, home, or anything else – and you make a profit on the sale, no value was lost over the lifespan, so the government gets your depreciation deduction back.

When you take depreciation, you’re lowering the value of that property for tax purposes. When you sell the property, your profit is computed by taking the sale price minus the depreciated value the asset.

Whether you are selling a single-family home, condominium, apartment building or other form of real estate, when the property has been depreciated, it elevates the profit you make on the asset. This has the impact of increasing your tax bill.

How to calculate depreciation recapture

Calculating depreciation recapture starts with the original cost basis of the property: the price of the home plus certain items like closing costs, plus any capital improvements you’ve made. You divide this by what the IRS deems to be the useful lifespan of rental property under either general or alternative depreciation systems to get your maximum yearly depreciation. This is multiplied by the number of years you own the home.

Let’s do a quick example. You bought 7 years ago an investment property for $400,000. It sold for $800,000. Your income is $199,000 per year as a single taxpayer. We’ll get into how this is taxed in a minute, but for now, let’s just calculate how much the IRS is entitled to recapture. Start by finding how much depreciation was taken every year, assuming you took the maximum allowable, using general depreciation:

$400,000 ÷ 27.5 = $14,545

This is multiplied by the number of years you owned the property.

$14,545 × 7 = $101,818

The IRS is entitled to get $101,818 that was previously depreciated from your income back.

How are investment properties taxed?

Before we get into taxation calculations, let’s speak generally about the way investment properties are taxed when they’re sold. Again, you should speak to a tax advisor about your personal situation.

Capital gains vs. ordinary income

Assuming a profit is made on the sale, owners of investment properties are subject to both capital gains tax and ordinary income tax if they’ve taken depreciation. If you make income above a certain threshold, you may be subject to 3.8% net investment income tax as well.

The portion of profits subject to depreciation recapture is taxed at ordinary income rates, usually limited to no more than 25% for real property under Section 1250. So the tax rates on up to $101,818 in profit get taxed at higher rates. The rest of the profit is subject to capital gains tax at the normal rate for your income level.

So how much do you owe in taxes? To start with, let’s remember we have $400,000 in profit. The first $101,818 is taxed at the maximum ordinary income rate because you’re in the 32% graduated tax bracket based on income.

0.25 × $101,818 = $24,455

The rest is taxed at the 15% capital gains level based on your income.

$298,182 × 0.15 = $44,727.30

When added together, the total tax bill comes to $69,182.30. Based on your filing status, you’re not subject to the net investment income tax.

One important caveat here is that if you hold the property for less than a year, it’s considered a short-term capital gain. That profit is always taxed at ordinary income rates. The long-term capital gains tax break you get kicks in if you hold the property for more than a year.

Deductions and depreciation

Of course, any taxes that you owe are reduced by legitimate expenses you can claim as deductions related to your rental business. The IRS has a whole publication for rental property, but expenses include the following, among many others:

• Mortgage interest
• Expenses related to repairs and improvements
• Legal fees

Forms and IRS guidance

When you sell business property, the IRS has you fill out Form 4797. It looks complicated, but there are also instructions and we recommend working with your tax advisor.

How can I avoid depreciation recapture?

The most common way to avoid depreciation recapture is to roll the proceeds from the sale of one property into the next one. This is called a 1031 exchange. But this will only delay depreciation recapture. The second you sell your last property and don’t buy another investment property, you must pay off the tax bill for the current and all the past properties, so it’s deferred and you have to keep track of it all the way along.

FAQ

Here are answers to common questions about depreciation recapture.

How do you avoid depreciation recapture in real estate?

You can never fully avoid it because eventually the bill becomes due. But you can defer taxes and recaptured depreciation by doing a 1031 exchange, plowing the money back into the next investment property. The tax payment comes when eventually you sell the last property without reinvesting

Is depreciation recapture always 25%?

The highest tax rate for depreciation recapture is 25%, but it could be lower. It depends on what income tax bracket you fall into.

What happens when you sell a fully depreciated rental property?

Fully depreciated rental property is pure profit when you sell it. So you pay back all the depreciation at your income tax rate, up to your cost basis in the property, with a max tax rate of 25%. Any profit beyond that follows capital gains tax rules.

Can I move into my rental property to avoid depreciation recapture?

The short answer is no. Turning rental property into personal property triggers depreciation recapture rules.

Do I have to pay back all depreciation on rental property?

There is a limit in that you can’t be taxed more than you make on the property.

The bottom line: Depreciation is a valuable benefit, but you can’t double-dip

Depreciation enables you to deduct from your taxes the loss of value expected to happen over time as business rental property is being used. Of course, if you sell that property for a profit later, there’s been no actual depreciation. Any depreciation you took is taxed at ordinary income tax rates up to 25%. After depreciation, regular capital gains taxes apply.

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