What Is Depreciation Recapture And How Can I Avoid It?

What is depreciation recapture, and how does it apply to assets such as real estate and property that you may have acquired? If you’re planning on selling an asset that you’ve depreciated for tax purposes, you’ll want to read the following guide.

Below, we take a closer look at how depreciation recapture can lead to a larger tax bill – and, with a little upfront planning, how you can avoid its impact on your finances.

What Is Depreciation Recapture?

“Depreciation recapture” refers to the Internal Revenue Service’s (IRS) policy that an individual can’t claim depreciation deductions for assets (thereby reducing their income tax) and then sell them for a profit without “repaying the IRS” through income tax on that profit.

By reporting the profit as ordinary income rather than as capital gains, which is taxed at a lower rate, the difference between the sale price and adjusted cost basis is “recaptured.”

What Is Depreciation?

Investment properties are depreciable, with depreciable assets available to investors ranging from the building (but not the land it sits on) to its contents. Noting this, the IRS has established various classes of assets and recovery periods of time over which these assets can be depreciated, based on their expected useful life.

For example, any residential property that has been placed in service for the last four decades is depreciated over an assumed useful life of 27.5 years. To calculate how much you can deduct in any given calendar year, simply divide your cost basis by the useful life of the asset to come up with your annual amount of depreciation.

Depreciation Recapture, Explained

Certain types of investments and capital assets may be depreciated for tax purposes according to the IRS, allowing investors to take tax deductions for depreciation. In turn, their ordinary income is reduced.

By splitting up and dividing the cost of an asset that they’ve acquired over several years and taking a tax deduction in each of these subsequent years for these sums (depreciating it), property owners can reduce their tax burden. However, at the same time, doing so can reduce the given asset’s depreciation-adjusted cost basis – a number that can come into play when calculating how much you’ll pay taxes on at a later date when the asset is sold.

While a helpful tool for homeowners and real estate investors, depreciation – which offers a handy way to reduce sums owed at tax time – can also lead to later tax bills. That’s because any gains on the sale of a property will be computed by subtracting the amount of this asset at its lowered depreciation-adjusted cost basis from the total sale price.

In other words, if you lower your cost basis in a single-family home, condominium, apartment, or other real estate holding, then sell it after the property has been partially depreciated, you may earn more money than anticipated – and that may be taxed as ordinary income.

How To Calculate 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.

Next, you’ll 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.

How Are Investment Properties Taxed?

Taxation on investment properties works differently than the way that you’re taxed for everyday earnings and income.

Before purchasing a real estate holding as an investment, it’s wise to educate yourself on these differences. Be sure to speak with a tax advisor about your particular situation.

Capital Gains Vs. Ordinary Income

Owners of rental properties are subject to two types of interrelated, but separately calculated taxes: capital gains and ordinary income.

Capital gains occur when profits are made on the sale of an asset such as a property. Capital gains come in two versions: short-term (when an asset has been held for a year or less) and long-term (when you’ve held an asset for more than a year) gains.

• Short-term capital gains: These are taxed similarly to the ordinary income (revenue from business or professional activity) that you earn in any given year, based on your individual tax bracket.
• Long-term capital gains: These are typically taxed at lower rates than short-term gains and ordinary income, and they’re based on their own alternate tax brackets.

In essence, if you purchase a property and then flip or sell it later for a profit, you can expect to pay short-term (under 1 year of asset ownership) or long-term (over 1 year of asset ownership) capital gains on the sale of your real estate.

Likewise, if you earn money from the rental of any given property, that money will be taxed as ordinary income according to your tax bracket.

Deductions And Depreciation

Note that any sums owed at tax time can also be impacted or reduced by operating and capital expenses. Operating expenses are costs required for the day-to-day functioning of your rental property business, such as those related to maintenance and upkeep. Examples include:

• Utility bills
• Property taxes
• Property insurance

Capital expenses are costs that you incur with an eye toward creating future benefit, like the purchase of new equipment or property upgrades. Each is treated differently for accounting purposes.

Bear in mind that capital expenses are recorded as assets on your balance sheet as opposed to expenses on your income statement, being investments in your business by nature. Over time, the asset is then depreciated, with annual depreciation expenses charged to your income statement, helping you enjoy deductions for tax purposes.

In other words, capital expenditures can impact your cost basis in any given property for purposes of calculating capital gains, but they can still help you reduce your ordinary income on a year-to-year basis.

Forms And IRS Guidance

To address taxes surrounding real estate sales (including on rentals), the IRS has mandated that any sale of rental properties be filed by completing IRS Form 4797, Sale of Business Property. The IRS has also published guidance on how to complete the form for taxpayers.

How Can I Avoid Depreciation Recapture?

If you’re looking to minimize your tax burden, a 1031 exchange – named for IRS Section 1031 of the IRS’s tax code – can help you avoid both depreciation recapture and capital gains taxes. However, under the terms of a 1031 exchange, you’re required to use the proceeds of the sale 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 that’s similar in nature 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 at the time that ownership is transferred to a new purchaser, but you can apply any sums earned toward increasing your overall real estate investment holdings.

The Bottom Line: Depreciation Is A Valuable Benefit, But You Can’t Double Dip

Depreciation is a useful tool for reducing 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 that 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.

Ready to build your real estate portfolio? Apply for approval for a new mortgage today.