Depreciation recapture tax is the IRS’ method of recouping depreciation deductions you took while you owned an investment property if the property actually appreciated rather than depreciated while you owned it.
When you own an investment property, you can take a deduction for the decrease in value that the asset experiences—in theory, it wears out. Just as you can take a depreciation deduction for equipment you need for your business, you can deduct the depreciation in the value of buildings and other improvements (but not land, which does not wear out.) The IRS has established standard depreciation schedules for commercial buildings at 39 years and residential buildings at 27.5 years. In contrast, equipment, vehicles, and other business costs (like leasehold improvements) have shorter depreciation periods because the assets don’t last as long as buildings.
For example, if you buy an office building for $300,000 and determine the value of the land is $50,000, you can depreciate the building over 39 years. To calculate the annual deduction, divide $250,000 by 39. You can deduct $6410 each year. Suppose you own the building and take the deduction for five years. The total deduction after five years is $32,050. If you sell the property for more than the depreciated value, the IRS will levy a depreciation recapture tax of 25 percent, or in this case, $8012.50 since the property did not lose value.
The two significant advantages of a properly executed 1031 exchange are the deferral of capital gains taxes and the deferral of depreciation recapture. Here is an example:
If you buy a commercial building for $500,000 and own it for five years, you can deduct $64,100 over those five years, which would then be subject to a 25 percent recapture tax. Suppose you sell the building for $700,000 for a long-term capital gain of $200,000. That $200,000 would be subject to 15 percent or 20 percent capital gains taxes. If your applicable rate is 20 percent, you will owe $16,025 in the depreciation recapture tax and $40,000 in capital gains assessment.
Executing a 1031 exchange instead of a traditional sale will allow you to defer both levies. The deferral allows you to reinvest the entire proceeds without losing a big chunk of your profit. But it’s vital to have professional assistance in completing a 1031 exchange. The rules and timelines are stringent.
The deferral of the depreciation recapture and the capital gains taxes are in effect until you sell the property. You won't lose the deferral if you don't sell the property. You can sell the property using another 1031 exchange and still maintain the deferral. However, both the old and new deferred amounts will accumulate as you conduct sequential 1031 exchanges.
You can transform the deferral into the elimination of the depreciation recapture tax by giving the property to an heir in your will. Since heirs receive the assets at a stepped-up basis, this action “resets” the value and eliminates the accumulated taxes.