Are you struggling to wrap your head around depreciation recapture? If so, you’re not alone.
When running your real estate business, you can account for the wear and tear of your property and any furnishings and appliances you own via depreciation. You can divide the costs associated with these items over several years through depreciation based on the schedules of asset classes that the internal revenue service (IRS) publishes.
Depreciation recapture refers to the portion of a gain you realize from selling a rental property taxed as ordinary income instead of capital gain. In other words, when you sell your property, the IRS taxes you on your depreciation deductions.
Still confused? That’s okay. In this post, we’ll show you how depreciation recapture works (and include examples), how to calculate it, and tell you if it can be avoided.
Here’s everything you need to know about depreciation recapture.
What is Depreciation?
Before we dive into depreciation recapture, you should first know how depreciation works. Investment properties naturally degrade over time due to use, weathering, and general wear and tear. It just happens. Your roof ages, wood slowly decays, and your appliances don’t work as well as they once did.
Luckily, there are tax benefits for depreciation assets, which can help you save money. The IRS lets real estate investors deduct their property’s cost for a set time: 27.5 years for residential real estate and 39 years for commercial real estate.
Unlike other items you can deduct, like a car, or a computer, which you write off as a business expense, your property will likely appreciate in value over time as long as you take care of it. In that sense, depreciation is often called a “phantom deduction” because you’re not losing anything, but you still get to deduct the cost. Put another way, real estate investors can reap the benefits of both depreciation and appreciation.
To qualify for depreciation:
- You must own the rental property
- You must own it for at least one year
- The property is being used (i.e., endures wear and tear) for your business or to produce extra income, like rent
How depreciation works
Now, let’s talk about math—and when it comes to depreciation and depreciation recapture, a lot of it is involved.
To calculate your depreciation expense, divide your property’s worth by the number of years.
Let’s say your residential rental property’s purchase price is $500,000. Since depreciation for residential properties is 27.5 years, your depreciation expense is:
$500,000 / 27.5 = $18,181.82
Your tenant for this property pays you $2,500/mo. After calculating all your income and expenses, you have a net operating income of $1,000/mo or $18,000 for the year. Unfortunately, you must pay taxes on that $18,000 because it’s unearned income. That’s also where depreciation comes in handy. If you’re paying a total of 25% federal income tax without depreciation or other expenses, you’d owe:
$12,000 x (25/100) = $3,000
Depreciation lets you subtract your depreciation expenses from your rental income:
$12,000 – $18,181.82 = -$6,181.82
In this scenario, you’ve actually lost money and won’t have to pay taxes—all thanks to depreciation.
With cost segregation, you can even take this a step further. Cost segregation accounts for the depreciation of specific items in your rental property, including flooring, cabinets, countertops, lighting, and appliances. For the sake of simplicity, we’re diving into cost segregation today.
What is Depreciation Recapture?
If depreciation is the teen who throws a party when their parents are out of town, depreciation recapture is the neighbor who calls and complains.
The IRS knows that rental property investors reap the benefits of depreciation, and they want their cut. If you sell your rental property, the IRS “recaptures” all the money you saved over the years via depreciation deductions, and the depreciation recapture tax rate is a hefty 25%.
Let’s use our earlier example to calculate depreciation recapture. If you were to sell that property after a year, you would owe the IRS:
$4,500 x (25/100) = $1,125
Keep in mind this is in addition to your capital gains taxes.
So while depreciation helps relieve your tax burden now, you will have to pay depreciation recapture taxes later on. Before you throw in the towel, let’s explore rental properties and depreciation recapture a bit further:
Rental Properties and Depreciation Recapture
As you’ve gathered by now, depreciation is pivotal in how much you’ll owe in taxes when selling your rental property.
Let’s say you decide to sell your property after ten years. If the purchase price was $500,000, you’ve written up $181,818.20 in depreciation expenses ($18,181.82 x 10). You will have to pay up to 25% in taxes on your depreciation expenses:
$181.818.20 x (25/100) = $45,454.55
In this case, your depreciation recapture rate is $45,454.55.
Depreciation Recapture and Capital Gains
Unfortunately, depreciation recapture isn’t the only thing you’ll be taxed on when selling your property. You’ll also have to pay a capital gains tax on your total realized gain, which is the profit you make when you sell investments for more than what you paid for them.
Let’s assume that you sold the property for $725,000. After your portion of closing costs and the real estate agent gets their cut, your total is $700,000. To figure out your total realized gain, you subtract the price you still it for minus your property’s remaining value:
$700,000 – $500,000 = $200,000
The amount of capital gains tax you pay depends on your income level (more on this later). The amount you pay is based on the rest of your gains after depreciation:
$200,000 – $45,454.55 = $154,545.45
Let’s assume your income level requires you to pay 15% in capital gains.
$154,545.45 x (15/100) = $23,181.82
Now, let’s put it all together. To recap:
- $725,000 – Total amount you sold the rental property for
- $25,000 – Closing costs and your real estate agent’s cut
- $45,454.55 – Depreciation recapture
- $23,181.82 – Capital gains tax
$725,000 – $25,000 – $45454.55 – $23,181.82 = $631,363.63
Remember, you also purchased the property for $500,000, so your profit after taxes is $131,363.63.
The upside of depreciation recapture
No one wants to pay extra money in taxes. In this scenario, the total depreciation recapture was $45,454.55. That’s a lot of money! Rather than getting upset about how much you have to pay back, look on the bright side—your total gains as a whole.
For one, you’ve also gained ten years’ worth of rental income at $2,500/mo:
$2,500 x 120 (total number of months) = $300,000
This income has likely helped you pay down your mortgage and other renting expenses. If you want to calculate your net operating income for the property instead, that would be:
$1,000 x 120 = $120,000
In addition, you’ve claimed $181.818.20 in depreciation. While the IRS recaptured $45,454.55, you still wrote off $136,363.65 that the IRS didn’t touch.
These numbers, along with the net profit of your sale, are much higher than what you had to pay in depreciation recapture.
There’s also a lesser-known fact about depreciation recapture: It only applies to the extent you gained on selling your property. In other words, if you sold the property for $525,000 (after closing costs and the real estate agent gets their cut), you may only have to pay recapture taxes on $25,000, even though your depreciation recapture is more significant than that.
Ordinary income vs. capital gains
Depreciation recapture is generally taxed as ordinary income and caps at a rate of 25%. The 2022 income tax brackets are as follows:
|Single Filers||Married, Filing Jointly|
|10% on income up to $10,275||10% on income up to $20,550|
|12% on income over $10,275 to $41,775||12% on income over $20,550 to $83,549|
|22% on income over $41,775 to $89,075||22% on income over $83,550 to $178,149|
|24% on income over $89,075 to $170,050||24% on income over $178,150 to $340,099|
|32% on income over $170,050 to $215,950||32% on income over $340,100 to $431,899|
|35% on income over $215,950 to $539,900||35% on income over $431,900 to $647,849|
|37% on income over $539,900||37% on income up over $647,850|
In other words, you’ll be taxed at 25% unless your total ordinary income is less than $170,050 or $340,099 if you’re married and filing jointly.
Your capital gain tax rates are a bit different. Since we’re talking about depreciation recapture, you usually don’t have to worry about short-term capital gains rates. Those are for properties you own for one year or less. You must own property for at least one year to qualify for depreciation.
The long-term capital gain rates are 0%, 15%, and 20%.
If you’re a single filer, your capital gain rates are:
- 0% if your income is $44,625 or less
- 15% if your income is between $44,625 and $492,300
- 10% if your income is greater than $492,300
Did we mention yet that this article requires a lot of math?
Can Depreciation Recapture be Avoided?
The most significant loophole in depreciation recapture is the 1031 exchange. The 1031 exchange gets its name from the IRS tax code, and it’s a legal strategy that lets you sell your property and then use the profit to buy a new one. When you do this, you can defer paying real estate taxes until you sell the next property. However, you can also use the 1031 exchange on that property! And the one after, and so on, and so on, if you’d like.
Here’s what this looks like in action:
Let’s return to the earlier example where you sell your rental property and must pay $45,454.55 in depreciation recapture taxes and an additional $23,181.82 in capital gains. That’s $68,637.37 altogether.
Suppose you instead put that money towards the down payment of a “like-kind asset” (i.e., a rental property somewhat comparable to the one you’re selling). In that case, you can avoid paying depreciation recapture and capital gains taxes!
In addition to buying a “like-kind asset,” there are two other rules you must follow to qualify for a 1031 exchange:
1. No touching the profits
You can’t even have them in your account. Instead, using an intermediary to hold the cash while waiting for your next real estate transaction to close would be best. You’ll be required to pay taxes on any of the profits you touch.
2. Identify and close in time
Here’s the stressful part: You must beat the clock to complete a 1031 exchange. From the day you sell your property, you have:
- 45 days to identify the property you plan to buy (you can identify up to three, just in case)
- 180 days to close on that property.
As any real estate expert will tell you, those short time frames make meeting this qualification difficult. We recommend starting your search before you sell your current property to get a jumpstart on this rule. Any extra time helps.
Still have some questions about depreciation recapture? We’ve got answers!
What are other assets subject to depreciation recapture?
While we’ve mostly talked about depreciation recapture in real estate, it’s not the only asset subject to depreciation recapture. You’re often also required to pay recapture taxes on equipment, furniture, and other assets.
Is there a limit to how much depreciation you can claim?
Under the Tax Cuts and Jobs Act, the maximum depreciation deduction increased from $500,000 to one million. This act also “increased the phase-out threshold from $2 million to $2.5 million.”
What happens if you don’t take depreciation on a rental property?
You’re not legally required to claim depreciation. However, if you don’t claim it, you’re missing out on one of the most significant tax advantages of owning a rental property. Depreciation can save you thousands—if not more—every year you can claim it.
If that’s not convincing enough, try this: If you decide to sell your rental property, you’re still required to pay the depreciation recapture tax, regardless of whether or not you’ve been claiming depreciation. You can try to avoid paying this tax, but you usually won’t succeed.
Why does depreciation serve as a tax shield?
Depreciation deductions reduce a company’s taxable income. Every year, the depreciation expense is the same for the duration of the asset’s “life cycle.” In some cases, depreciation might even bring you into a lower tax bracket.
Figuring out how depreciation recapture works are challenging. While paying extra money during the sale of a rental property isn’t fun, the amount you save thanks to depreciation makes it well worth it.
If you still have more questions on the matter, check out some of our other posts on depreciation, or ask our experts in the forums.
More from BiggerPockets: 2023 State of Real Estate Investing
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.