Selling an investment property for a gain can result in a large tax bill. Some of that bill may include paying back depreciation. This is called depreciation recapture. The recaptured depreciation is taxed at a different tax rate. Does a 1031 defer depreciation recapture taxes or does depreciation continue as if it is the same property?
What Is Depreciation (Recapture)?
Depreciation decreases net income, which decreases taxes owed. This is a great benefit to real estate investors. Depreciation is a non-cash flow expense since it doesn’t affect an investor’s bank account.
However, when the investor sells the property, the IRS will want to recoup some of that depreciation. This is called depreciation recapture. Unlike long-term capital gains, depreciation recapture is taxed at 25% and is independent of the investor’s income level.
Even if an investor doesn’t take depreciation while owning a property, taxes are still owed as if the investor took the depreciation.
Depreciation affects the cost basis of a property. Let’s say an investor purchases a property and holds it for five years. The cost basis can be calculated as:
Purchase price: $400,000
5 years depreciation = $73,000
Cost Basis: $327,000
Sold for $500,000 (gain of $100,000)
However, the taxable amount on the sale is $173,000 since depreciation recapture must be factored in.
From the above, depreciation on a residential property can be taken for 27.5 years (or 39 for commercial). This means the annual rate of depreciation is 3.636% per year (1/27.5). We arrive at $72,000 by $400,000 x 3.636% x 5. The $73,000 will be taxed at 25%, while the $100,000 will be taxed at the long-term capital gains rate.
1031 Exchange and Depreciation Schedules
What happens to depreciation recapture if an investor decides to do a 1031 exchange instead of selling the property outright? In that case, there won’t be any taxes owed as a 1031 exchange will defer those taxes. This includes depreciation recapture taxes.
When the investor exchanges into another property, the original non-depreciated cost basis plus the gain in value carries over without the impact of depreciation. Using the previous example, the non-depreciated cost basis is $327,000 + $100,000 = $427,000.
The investor isn’t done with depreciation and has two options for how to continue with depreciation on the acquired property. These options are known as single schedule and two schedule depreciation.
Single schedule depreciation is common because of its simplicity. In the single depreciation method, the investor uses the new adjusted cost basis and divides it by 27.5 years for residential properties (or 39 years for commercial). The result provides the annual amount to depreciate for the acquired property.
The two schedule method, which the IRS prefers, continues the depreciation schedule of the relinquished property while also using the cost basis of that property. From the above example, the relinquished property was held for 5 years, so the remaining depreciation is 22.5 years.
A new depreciation schedule is established for the replacement property for the full 27.5 years. The replacement property uses the new cost basis, generally the difference in the value of the acquired property over the relinquished property.
The main advantage of the two schedule method is basically double depreciation. The relinquished property’s depreciation carries on until it expires in 22.5 years. This depreciation method will often be far greater than if the single method was used.
When one weighs the benefits of the two schedule method against the single schedule method, it will likely be clear that the tax shelter is larger. However, the complexity of calculating depreciation also increases with the single schedule method. This is why working with a real estate account is essential to ensure correct calculations and conclusions of the depreciation schedule choice.
