Depreciation Recapture on Rental Property

Depreciation recapture on rental property concerns a tax provision on capital gains due to depreciation commonly faced by real estate investors selling their rental income property.

In essence, depreciation recapture is the way the Internal Revenue Service is able to “recapture” taxes on all or part of the gain on the disposal of the asset as ordinary income, rather than solely as capital gain (which is often at a lower rate).

The provision is far from simple. In fact determining the amount subject to recapture is typically characterized as one of the most confusing income tax liabilities confronting real estate investors selling rental property. Mostly because the specific rules are detailed and are subject do change.

So the following article intends to help you understand the general concept of depreciation recapture only. Investors must always consult with qualified legal and tax advisers when making any real estate investing decisions.

Okay, let’s walk through the process starting at the beginning.

The allowance for depreciation (or “cost recovery”) is one of the biggest tax-deduction advantages rental property owners are granted by the IRS during the course of their ownership.

According to the current internal revenue code, from the time real property is placed into service until the time the title is transferred or reaches the depreciable limit set by the IRS, investors can deduct an amount for cost recovery each year on the physical structures (called “improvements”) as an income tax deduction.

The amount of that annual deduction is determined by the asset’s “useful life” as specified in the code. Currently the useful life for residential rental property (buildings occupied by tenants as housing) is 27.5 years and for non-residential rental properties (buildings occupied for business purposes) 39 years.

For example, say you purchase an apartment complex for $800,000 of which 70 percent is attributable to physical improvements. According to the IRS you would have a “depreciable basis” of $560,000 (800,000 x.70) which you can depreciate according to its useful life. Thereby dividing that depreciable basis by useful life (560,000 / 27.5) you establish that you can claim a deduction for cost recovery to offset your taxable income each year in the amount of $20,364.

Please note that both the year of acquisition and year of sale would compute a slightly different amount due to the “mid-month convention” provided by the tax code. In the real world, of course, this convention would be considered, but for our purposes the convention is ignored just to keep it simple.

Fair enough. So let’s continue by showing you why the Feds stepped in with depreciation recapture and IRS Code Section 1250 was created.

Since the taxpayer earned a benefit by offsetting ordinary income in owning depreciable rental property, the IRS concludes that the taxpayer must pay them back for that benefit when the property is sold.

Let’s consider an example to give you the idea. Assume that you sell your investment real estate at the end of five years for $900,000. Here’s how the internal revenue service determines your gain on the sale.

1. First, the total amount of deductions claimed during the holding period is computed by taking your annual deductions for depreciation by the number of years claimed (20,364 x 5), or $101,820.

2. Secondly, your property’s “adjusted basis” is computed by lowering its original basis (purchase price) by the amount of deductions you claimed (800,000 – 101,820), or $698,180.

3. Finally, your “gain” is computed by deducting the property’s adjusted basis from its sale price (900,000 – 698,180), or $201,820.

It’s worth noting how the IRS benefits from this method. For example, if your gain on sale was simply computed as sale price less your original basis (900,000 – 800,000), your gain would be $100,000. In this case, however, your gain increases to $201,820, which means that the IRS can collect taxes from you on an additional $101,820.

Okay, now let’s consider how the taxes are levied.

Since the tax on capital gain income is often less than taxes on ordinary income, rather than merely taxing the investor’s entire amount at the capital gains rate, the IRS instead applies depreciation recapture. This enables them to take the total deductions for depreciation claimed by the investor back into income and tax it as ordinary income.

Here’s how it works.

The $101,820 depreciation deductions taken by the real estate investor is taxed at the cost recovery recapture tax rate, and the remaining $100,000 (201,820 – 101,820) is taxed at the capital gains rate.

For example, if the recapture tax rate is 25% (the maximum allowable) and the capital gains tax rate is (say) 20%, then due to the sale, the taxpayer would owe the Feds $25,455 (101,820 x.25) plus $20,000 (100,000 x.20), or $45,455.

Of course this tax method for depreciation recapture can cause a significant tax impact for real estate investors who sell rental properties. Consider this along with the illustrations above to see what I mean.

Without any consideration for depreciation deductions at all, the investor’s tax obligation at the time of sale would compute merely as selling price less purchase price (900,000 – 800,000), or $100,000 taxed at the capital gains rate (100,000 x.20), or $20,000.

Whereas with this consideration, the investor’s obligation to the IRS is based upon an increase to gain brought about by depreciation deductions and then taxed partially as ordinary income and capital gains, which, as we illustrated, results in a tax obligation of $45,455. In other words, the real estate investor’s obligation to the internal revenue by this method is increased by $25,455.

Okay, but even if we assume the higher adjusted gain of $201,820, we can still see how depreciation recapture impacts the investor. Without it, the investor’s obligation to the IRS would be based upon that entire amount taxed solely at the capital gains rate (201,820 x.20), thus resulting in a tax obligation of $40,364. With it partially taxed as recapture and the remainder as capital gains, however, the obligation becomes $45,455 (an increase of $5,091).

Just one more thought and we’re done.

Several conditions must be met at the time of a rental property sale for the depreciation recapture tax to be levied. The tax event takes place only at the time the asset is disposed. Secondly, the depreciable real estate must be sold after one year of ownership otherwise it is considered short-term capital gains and recapture doesn’t apply. Thirdly, the investor must show a recognized gain as a result of the sale (there is no recapture when the taxpayer takes a loss). Fourthly, the amount subject to recapture cannot exceed the gain realized and cannot exceed a tax rate of 25 percent.

Here’s to your real estate investing success.