People often refer to the tax advantages of investing in real estate. In particular, depreciation – a “cashless expense” – frequently allows for positive cash flow while a property still recognizes a loss for tax purposes. But, what the IRS giveth, the IRS taketh away. When it comes to the tax advantages of depreciation, the IRS uses depreciation recapture to claw back some of those benefits when you sell a property. As such, we’ll use this article to answer the questions: what is depreciation recapture, and why does it matter?
Specifically, we’ll cover the following topics:
- Real Estate Depreciation Overview
- What is Depreciation Recapture?
- Final Thoughts
Real Estate Depreciation Overview
The IRS allows businesses to deduct most ordinary and necessary expenses when incurred. That is, these expenses lower your current taxable income. This current deduction treatment corresponds with the accounting principle of matching expenses to the periods in which those expenses help generate income.
But, what if a purchase will generate income over multiple years? If you buy a rental property, it can generate income over an extended period of time – not just a single year. As a result, the IRS doesn’t let you deduct 100% of a real estate purchase in the year of acquisition. You can’t spend $500,000 on a rental property, then turn around and reduce that year’s taxable income by $500,000.
Instead, the IRS uses an accounting treatment called depreciation for these larger purchases. Rather than deduct 100% of cost in the acquisition year, real estate investors deduct a portion of the purchase over a number of years. In this fashion, you match a portion of the acquisition cost to multiple years of income. (NOTE: You can only depreciate the cost of property improvements – not land).
While a variety of depreciation methods exist, the most common ones for real estate are called straight-line depreciation. The IRS’s Modified Accelerated Cost Recovery System, or MACRS, dictates these straight-line periods. For residential real estate, owners depreciate property over 27.5 years. For commercial property, the depreciation period extends to 39 years.
Let’s use the above purchase of a $500,000 rental property as an example. Assuming you made no capital improvements following purchase, that $500,000 becomes your taxable basis. And, if $400,000 of that purchase price is allocated to the property improvements (i.e. the home), that becomes your depreciable basis (remember, you cannot depreciate acquisition cost allocable to land). As a residential property, you divide this depreciable basis by 27.5 to determine an annual depreciation expense of $14,545 ($400,000 depreciable basis divided by 27.5 years).
In other words, every year you own that rental property, you can reduce your taxable income by $14,545, despite not actually having an associated cash outlay of $14,545. This “cashless expense” often allows rental properties to generate positive cash flows while recognizing a taxable loss.
What is Depreciation Recapture?
Despite the incredible tax benefits of depreciation, the IRS claws back some of that benefit if and when you eventually sell a rental property. Through a process known as depreciation recapture, the IRS assesses a flat tax of 25% on a property’s total eligible straight-line depreciation during the ownership period. That is, even if you don’t claim depreciation, the IRS will still assess the depreciation recapture tax when you sell a property.
A Depreciation Recapture Example
Continuing the above example, let’s assume you owned and rented out the property for 10 years. At the 10-year mark, you sell the property for $750,000. This sale price (ignoring transaction costs), leads to a capital gain of $250,000. We calculate this by subtracting the $500,000 taxable basis from the $750,000 sale price. At the 15% long-term capital gains rate, this $250,000 gain translates to $37,500 in capital gains taxes ($250,000 capital gain times 15% rate).
But, you also must account for depreciation recapture. This 10-year period includes $145,450 in eligible depreciation ($14,545 annual depreciation expense times 10 years). At a 25% flat depreciation recapture rate, this translates to $36,363 in recapture taxes ($145,450 total depreciation times 25% rate).
Accordingly, if you failed to account for depreciation recapture when selling this rental property, you’d underestimate your tax bill by $36,363!
Final Thoughts
Fortunately, strategies exist to defer or, in some cases, avoid depreciation recapture taxes. For novice real estate investors, it’s critical to have a basic understanding of depreciation recapture. Without this foundation, you’ll miss opportunities to take advantage of these tax-planning strategies.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available passive real estate investment opportunities – and the associated tax implications.