Many property owners or business owners have expensive or valuable assets. To lower their reported income, they can use those assets’ depreciated value to take special deductions on their taxes. In the short term, depreciation deductions can save entrepreneurs or real estate investors lots of money on their yearly taxes. However, the IRS eventually comes calling! It never forgets the value deducted from your assets and will eventually require you to pay taxes on the property once you sell it. This process is called depreciation recapture. Let’s take a closer look at depreciation recapture and break down how you can avoid it by using any profits you make from selling property or real estate in a specific way.
What is Depreciation Recapture?
In the simplest terms, depreciation recapture lets the IRS collect taxes on the financial gain you make from selling an asset like real estate or property. When you buy an asset like a building or a vehicle, the IRS lets you deduct some of the value of that asset as it depreciates over time. This results in you paying fewer taxes in the short term. But if you ever sell that asset, the difference between the sale value of the asset and its depreciated value will be accounted for. This extra income will be taxed on your next tax return, thus “recapturing” the lost taxable income. To understand depreciation recapture more fully, you first have to understand depreciation.
“Depreciation” is most commonly used by taxpayers or businesses to write off the progressively lost value of certain fixed assets, like equipment or real estate. Over time, this allows the taxpayer to benefit and/or earn revenue from that asset’s value without having to pay taxes on that asset at its original price. The “depreciation expense” is the value the asset gradually loses over time. For example, most homes depreciate, as do most cars, because they are used and become less valuable to future buyers. An even better example is a business commercial property.
Once a business owner buys the property, they can use depreciation to write off some of its value as its value decreases with time. But the business owner still earns revenue from the asset, increasing their net income. Although depreciation recapture most often applies to the sale of real estate, it can also apply to other assets like equipment or furniture. Any capital assets are theoretically vulnerable to depreciation recapture under the right circumstances.
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How Does Depreciation Recapture Work?
The IRS publishes distinct depreciation schedules for different types of assets, including property, equipment, vehicles, and more. The depreciation of those assets divides the cost associated with using the assets over a set number of years. Taxpayers can look at the IRS depreciation schedules to determine how much of an asset’s value they can deduct from their tax return each year. They’ll also find a term limit for those deductions. Taxpayers do this because deducting annual depreciation for expensive assets lowers their income, meaning they have to pay fewer taxes for that fiscal year. But depreciation recapture kicks in should the taxpayer ever decide to sell the asset.
If a depreciated asset, like a used truck, is sold for a gain, the taxpayer’s ordinary income tax rate, whatever that is, will be applied to the amount of depreciation previously deducted from that asset. This lets the IRS collect taxes from profitable sales of assets that taxpayers previously used to offset their taxable income. Naturally, businesses and individuals with valuable assets usually try to avoid depreciation recapture.
Rental Property Tax Deductions
So, what tax deductions can usually make? Let’s start with rental property deductions. In general, any legitimate expenses that relate to your rental property can be deducted, such as:
Any operating expenses and maintenance fees, including costs for repairs
Your mortgage insurance
Any property taxes
The cost of buying or improving rental property (though the costs have to be depreciated across the “useful life” of the property rather than in one lump sum)
All these deductions can be taken during the same year in which you spend money. Just report the deductions on your Schedule E form. But remember, if you sell the rental property, the IRS will tax you on the depreciation deductions!
Which Rental Properties Can You Depreciate?
According to the IRS, you can depreciate any rental property if:
You own the property outright, even if you service a debt on the property
You fully use the property for your business or another income-producing activity, like renting to tenants
The rental property in question has a set useful life. In other words, the rental property has to eventually wear out, become obsolete, or lose its value. It has to depreciate. Luckily, all rental properties qualify for this attribute
The rental property must be expected to last at least one year
On the other hand, the IRS also places some limitations on properties you cannot depreciate. These include:
Rental properties that you put in service and sell to another investor within the same fiscal year
Raw land, which doesn’t usually become obsolete or wear out
You also cannot depreciate the costs for landscaping, planting, or clearing land. The IRS considers those costs to be part of the overall cost of purchasing and developing land.
When Can You Start Depreciating Property?
It can be tough to know when to start deducting depreciation for your rental investment if there are multiple major dates in your investment journey. For example, if you buy a rental property on January 10, then make the property ready for renting by April 11, and then don’t start your first tenant’s lease until May 12, which of those dates should you use for depreciation purposes? According to the IRS, you can start depreciating any rental property or investment as soon as it is “in service.” In short, the property is to be ready and available to potential tenants to use as a rental home. In the above example, your rental investment was fully ready for a tenant by April 11, even though you didn’t get a lease and someone didn’t start living in the property until May 12. Under these rules, you can start depreciation for your tax breaks on April 11.
How Much Can You Depreciate Yearly?
You’ll also need to remember that the IRS limits how much you can depreciate off each asset you on every year. Different classes of assets, such as vehicles, rental properties, and expensive equipment, have different depreciation limits or caps. The IRS uses the Modified Accelerated Cost Recovery System or MACRS for depreciating any residential rental property placed in service after 1986. If your property qualifies, you’ll use the above system, which spreads all depreciation deductions over the projected useful life of said property.
According to this system, any residential rental property has a useful life of approximately 27.5 years. For a real estate investor, this means you can depreciate 3.636% of the total cost basis of the property every year. The “cost basis” is simply the initial amount you paid to purchase the property, regardless of whether you financed it or bought it outright. Note that the cost basis also includes ancillary fees like title fees, transfer fees, and more. The cost basis further includes the improvements you might make to a rental property after buying it. However, for the improvements to qualify, they have to add “real” value to the property, such that they serve as a good reason for you to increase the price or value of the property. These can include amenities like pools or gyms for tenants, AC, and so on. Note that the cost basis does not include other costs, such as:
The rent you pay before closing the deal
Any fire insurance premiums or similar fees
The costs to refinance a loan, to get credit reports, to get mortgage insurance premiums
Even with these guidelines, rental property depreciation can be difficult for investors that need to depreciate partial years of rental property ownership. Say that your rental property has only been in service for part of the year. In that case, you can’t depreciate the entire yearly value of 3.636%. Fortunately, the IRS breaks down how much you can depreciate for a rental property based on whichever month you put it into service. The depreciation values are:
If you started depreciating your property in any of these months, you’d depreciate according to the above values rather than the full 3.636% amount. Remember that your cost basis only covers the value of the building, not the land or any improvements to the land you may have ordered. The cost basis does include the closing costs, improvements to the property directly, and so on. You can keep depreciating your property until the 27.5 years of the property’s useful life are up, or you retire the property. “Retiring” a rental investment property means that you don’t use it as an income-producing property. You abandon it, you sell it or exchange it for another property, you convert it to a different use, or it is destroyed.
How to Calculate Depreciation Recapture
Let’s break down an example. Say that you purchased the property for $100,000 and paid $20,000 for improvements and $15,000 in closing costs. This would make your total cost basis $135,000. If you could start depreciating this property in April, you would have a depreciation rate of 2.576%. Plug the number into your total cost basis and you get a depreciation value of $3477.60. The equation to use would be:
135,000 x 0.02576 = 3477.6
Remember, the percentage of depreciation is represented mathematically two places from the decimal point when calculating. This is how much you can depreciate for the first year of your rental property’s service life, but you can depreciate it for the full 3.636% value for every year after.
Section 1245 Depreciation Recapture
Section 1245 depreciation recapture is used to calculate any income tax or capital gains tax you may owe on a sold asset. To calculate this you will start with the cost basis of the item, then minus all depreciation on that item, and finally add in your final sale price of the item. Your calculation will look like this:
(Original Item Price – Accumulated Depreciation) + Final Sale Price of Item = Realized Gain
If the realized gain ends up being negative (a realized loss), there is no depreciation recapture as you sold the item for a loss and will not need to pay income or capital gains taxes. However, if the realized gain is a positive number you will need to pay income tax or capital gains tax on that amount. You will then compare the realized gain to the accumulated depreciation. Whichever number is smaller is your depreciation recapture. Any amount of realized gain above the initial purchase price of the asset will be taxed as a capital gain, and all accumulated depreciation will be taxed as normal income. This is because the asset didn’t actually depreciate, so the tax breaks that you were getting for this asset via depreciation are now negated and you will need to pay that back in the form of an income tax.
Depreciation Recapture On Rental Properties
Let’s say that you want to retire your rental property by selling it. You’ve had the property for several years and have thus depreciated it on your prior tax returns. Therefore, depreciation recapture will almost certainly kick in once you sell the property. Depreciation places a key role in how much you’ll owe in taxes when you sell the property. After all, the depreciation expenses lowered your cost basis for the property over several years.
Let’s say that you hold the above rental property for a single year and decide to sell it for a profit. In that case, you’ll end up paying long-term capital gains taxes. Tax rates can be between 0% and 20%, depending on how much money you report on your income. Additionally, if you are in a higher than average income tax bracket, you might also need to pay a 3.8% net investment income tax.
But let’s refocus; you’ll need to pay for depreciation deductions you made previously. The IRS wants you to pay some of the money back from those deductions through depreciation recapture.
Your depreciation recapture is capped at 25% for rental properties and is ultimately based on your normal income tax rate. Depreciation recapture is applied to any amount of your gain that can be attributed to the depreciation deductions you took previously. To report depreciation recapture to the IRS, do so on Form 4797 or Sales of Business Property.
Let’s do another example so you can fully grasp the concept: Say that you purchased a rental property for $150,000 and held it for 10 years. You wrote off $54,540 in total depreciation deductions (assuming you used the 3.636% deduction rate the entire time). That would make your adjusted cost basis for the property after 10 years of service $94,460 (it’s the depreciated value subtracted from the initial $150,000 value of the property) So, say that you sell the property for $300,000 or double the original asking price. That means you realize a total gain of $205,540 ($300,000 minus the $94,460 of your property’s remaining value). Since your gain is so high, you’ll have to pay up to 25% or so depending on your normal tax rate for whatever parties tied it to the depreciation deductions. If you needed to pay the maximum amount in this example, you would need to pay the IRS $13,635 or 25% of your initial depreciated value. Then, the rest of your gains would need to be taxed at the normal long-term capital gains rate, such as 20%, on $192,175. In this example, it would work out to be $38,435. In total, you may need to pay $52,070 because of depreciation recapture and capital gains taxes.
How to Avoid Depreciation Recapture
So, it’s no secret why many investors look to avoid such high tax payments whenever they sell one of their real estate properties. There are ways in which you can minimize or even avoid depreciation recapture. One of the best ways is to use a 1031 exchange, which references Section 1031 of the IRS tax code. This may help you avoid depreciation recapture and any capital gains taxes that might apply. However, a 1031 exchange requires you to use the proceeds of the sale to invest in a new investment property, such as another rental building.
This allows you to delay your capital gains and depreciation recapture taxes by using the money from the sale to continue running your rental business. It’s a slick way to avoid depreciation recapture based on a technicality, as you aren’t really getting any profit from selling your property if you use it to fund your business for the future.
All in all, depreciation can be a great way to save money on taxes in the short term. But in the long term, it can really dig into your coffers and cause you to make much less of a profit from selling real estate or other assets than you might expect. To that end, carefully consider whether to deduct property depreciation from your taxes and make sure you understand depreciation recapture.
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