What is depreciation recapture on sale of rental property

When you typically invest in an asset, such as a car or computer, it is expected that this item will gradually decline in value as newer, more powerful or sophisticated models are introduced. In the world of tax lingo, this process is commonly defined as depreciation. The Internal Revenue Service allows asset owners to deduct the value of an item over its lifetime as part of asset depreciation. The same rules apply for real estate, with one significant caveat. When you purchase real estate, particularly in areas where property values are rising, it is quite likely that the value of your asset (in this case, the home you have purchased) will rise instead of fall. Although you are still allowed to claim a yearly deduction on the depreciation of this asset, you will be required to pay what is known as a depreciation recapture tax if you decide to sell it for a higher price than its current depreciation value.

Depreciate Your Asset

Prior to selling your property, you will have the ability to continually deduct the fixed depreciation amount on your property, determined by the total cost basis of the property divided into 27.5 equal parts. This is due to the fact that the IRS considers the typical life of a property to be 27.5 years. If, for example, you have purchased a rental property in San Francisco for $3 million dollars, you will be able to deduct $109,090.90 on a yearly basis as part of your depreciation. This assumes, of course, that you have not sold the property.

Understand the Depreciation Recapture Tax

If you decide to sell your rental property for more than its current depreciated value, you will be required to pay what is referred to as the depreciation recapture tax. Essentially, this amounts to a 25 percent tax on the amount above depreciation value that your property sells for. As you can imagine, this could be quite expensive if your property value has risen significantly. Depreciation recapture tax is reported on Schedule D of IRS Form 1040.

With that in mind, it is not uncommon for property investors to avoid depreciation recapture tax entirely by investing the funds gained through the sale of one property immediately into a similar purpose. The IRS allows for property investors to avoid paying taxes of any kind on property revenue if they decide to reinvest in "like kind" property, i.e. real estate or land to be used for commercial purposes. This is known as a Section 1031 exchange. This is a tool utilized by many property investors who continually buy and sell rental homes for profit.

If you’re like most investors, you own a rental property to make a profit. They often earn cash flow as long as you can keep them occupied. The property may also appreciate leaving you with a nice profit when you decide to sell.

Before you sell the property, though, you’ll need to understand what happens when you sell a rental property. Most importantly, understand the depreciation recapture taxes as it often sneaks up on investors in the final hour.

Depreciation recapture tax is a tax on the depreciation you wrote off while you owned the property. Once you sell, Uncle Sam wants his portion of the expenses you wrote off and now earn back by selling the property.

Table of Contents:

What Is Depreciation On A Rental Property?

As a real estate investor , you can claim depreciation on the rental property, even if its value increases. The deprecation exists on paper only – and only for the IRS. You may only depreciate the building, not the land.

On average, the land takes up 20% of the home’s value , but check your tax bill or latest appraisal for accurate numbers. Each property has a different land and building value. For example, if you bought a home for $200,000 and the tax bill shows the land is 20% of the home’s value, your depreciation cost basis is 80% of the purchase price or $160,000. You can’t depreciate the $40,000 land value.

You may depreciate the property as soon as you ‘place it in service.’ If you buy the home on June 1 but take 6 months to fix it up and advertise its availability, you can’t start depreciating it until Jan 1 or the date you put it in service. This date applies whether or not you have tenants – as long as you list the property for rent, it counts.

You depreciate the home over its useful life, which according to the IRS is 27.5 years or 3.63% of the cost basis annually. Your cost basis is the cost of the home minus the land’s value plus the cost of any improvements that add value to the home. You may not include the cost of getting the loan , rent paid prior to closing, or fire insurance premiums, though.

What Is Depreciation Recapture?

The depreciation deduction lowers your tax liability for each tax year you own the investment property. It’s a tax write off. But when you sell the property, you’ll owe depreciation recapture tax.

You’ll owe the lesser of your current tax bracket or 25% plus state income tax on any deprecation you claimed. Here’s the kicker – even if you didn’t claim the depreciation expense, you’ll pay depreciation recapture tax, so make sure you take the deduction when eligible.

The only time you don’t owe depreciation recapture tax is if you sell the home for a loss. Let’s say the market dropped drastically and you can’t afford to keep the home any longer. You cut your losses and sell for what you can, selling for an amount less than you paid originally. You claim a loss on your taxes and don’t owe a recapture tax.

Depreciation Recapture Tax is Not As Complex As You Think

Provided you sell the property for more than you bought it for, you are liable for depreciation recapture tax.

To work out this amount, you simply need to calculate how much depreciation was claimed during your ownership of the property, and multiply the total by your ordinary income tax rate.

So, if you owned the property for 10 years, your income tax rate is 18% and you claimed $40,000 in depreciation over those 10 years, the depreciation recapture tax would be $7,200 (ie $40,000 * 18%)

Depreciation Recapture Example

Let’s assume you purchased a rental property for $200,000, claiming a total deprecation of $55,000 over 10 years, and then sell the property for $240,000. Now let’s dissect the numbers in a relatively simple format.

• Rental Property Original Purchase Price: $200,000
• Total Depreciation Claimed over 10 Years: $55,000
• Original Cost Basis: $160,000

Step 1: Workout The Rental Property Depreciation Recapture Tax Amount

If your ordinary income tax level is 20%, then you simply multiply the total depreciation amount ($55,000) by 20%.

• Income Tax Level: 20%
• Total Depreciation: $55,000
• Depreciation Recapture Tax = $55,000 * 20%
• Depreciation Recapture Tax = $11,000

Step 2: Workout The Capital Gains Tax Amount

This is where the adjusted cost basis of the property becomes important. It has a direct impact on the total capital gain.

• Original Cost Basis: $160,000
• Adjusted Cost Basis: Original Cost Basis – Total Depreciation
• Adjusted Cost Basis: $160,000 – $55,000
• Capital Gain = Rental Property Sales Price – Adjusted Cost Basis
• Capital Gain = $135,000
• Capital Gain Tax Amount = $135,000 * 15%
• Capital Gain Tax Amount = $20,250

Step 3: Add these two numbers together to get the total tax owed

• Total Tax Payable = Depreciation Recapture Tax + Capital Gains Tax
• Total Tax Payable = $11,000 + $20,250
• Total Tax Payable = $31,250

What portion is capital gains tax, and what portion is depreciation recapture tax?

The depreciation recapture amount is determined by the total amount of depreciation that you claimed during your ownership of the property, and your personal income tax rate.

The rest of the ‘gain’ is taxed at the appropriate capital gains tax rate.

Assuming you hold the property for more than a year, your long-term capital gains tax rate will either be 0%, 15% or 20%, depending on the amount of the capital gain and your marital status.

The table below provides a breakdown, showing how to work out the capital gains percentage, depending on how much money you make when selling the rental property.

Rental Property Capital Gains Tax Rate Table

The IRS Depreciation Rules

Who does the IRS assume depreciation a rental property? If the home meets the following requirements, it qualifies:

• You own the property outright or with a mortgage on it
• You own the home as a part of your business (aka you rent it out)
• The property has value
• The property has a useful life of at least one year

If you buy a rental property and sell it within the same year, you can’t depreciate it and don’t have to worry about depreciation recapture tax.

Final Thoughts

Rental property depreciation gives you greater cash flow while you own a property and delays the taxes you owe until you sell a rental property. It’s like an interest-free loan, but keep the taxes in mind. When you sell the property, you’ll realize a lower profit because you’ll owe the taxes. There’s no getting around it, even if you don’t take the deductions, so take advantage while you can and be aware of the tax liability when determining the price to sell the home.

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How do you calculate recapture of depreciation?