There are many costs involved when selling a rental property. One of those is related to depreciation. Where depreciation giveth, it also taketh away. The IRS will claw back some of the depreciation expense taken during the holding period. This isn’t just a simple number. Some calculations are involved in determining the amount of depreciation that investors must pay back at the time of sale.
What Is Rental Property Depreciation?
Depreciation is a way for investors to recover costs on income-producing properties due to deterioration. The amount of depreciation an investor can declare is based on the property’s expected lifetime. The lifetime of a property is categorized as land, residential, or commercial. Depreciation is classified as a capital expense and is taken annually.
Two main categories investors utilize with depreciation expense are residential and commercial properties. Each has a specific lifetime expectancy, which determines the annual depreciation rate as follows:
Residential property = 27.5 years or 3.6% per year.
Commercial real estate = 39 years or 2.6% per year.
On a $750,000 residential building, the annual depreciation expense is equal to $27,272.
Note that land can’t be depreciated. But improvements on land can. Improvements include fencing, lighting, and paving for a parking lot. Land improvements are depreciated over 15 years. Building content improvements are depreciated over 5-7 years.
Non-Cash Flow expense
Depreciation isn’t an out-of-pocket expense. Although it is an expense, it doesn’t impact an investor’s bank account. It’s a non-cash flow expense, sometimes referred to as a phantom expense. Nevertheless, it still has the advantage of shielding/reducing tax-generating income.
This is one of the main reasons investors like real estate. They get a reduction in taxable income without having to pay anything extra for it (i.e., a non-cash flow expense). In some cases, the depreciation expense in a given year might be more than income generated from rental properties after operating expenses have been factored in. This will result in a loss for the year and no taxable income.
Depreciation Recapture
Depreciation recapture is based on the amount of depreciation taken over the holding period for the property. Depreciation recapture occurs whether depreciation was taken or not.
Depreciation recapture is claimed at ordinary income tax rates but capped at 25%. This cap is especially beneficial to high-income earners.
So what does depreciation recapture look like at the time of sale? Below is an example of how to calculate depreciation recapture in four steps:
1.) First, calculate the adjusted tax basis:
Original Equity Interest: $750,000
Add: Closing and Transaction Costs $5,000
Add: Total Spent Improving/Repairing $0
Less: Depreciation Taken During Ownership ($500,000)
Adjusted Tax Basis: $255,000
2.) Calculate the realized gain:
Selling Price of the Property $1,500,000
Less: Qualified Closing Expenses ($125,000)
Net Selling Price $1,375,000
Less: Adjusted Tax Basis ($255,000)
Less: Passive Activity Losses $0
Realized Gain (Loss) $1,120,000
3.) We multiply the amount of depreciation taken by 25% to get depreciation recapture:
25% x 500,000 = $125,500
Depreciation recapture is a tax owed on top of any other taxes owed, such as capital gains, state taxes, and the medicare surtax.
4.) Finally, we add the various taxes together to get the full tax impact. We’ll use a 20% capital gains tax rate and a 5% state tax rate.
Federal Capital Gains Tax: 20.00% x $994,500 ($1,120,000 - $125,500) = $198,900 *
Section 1411 Medicare Surtax: 3.80% x $1,120,000 = $42,560
Effective State Capital Gains Rate: 5.00% x $1,120,000 = $56,000
$125,500 + $198,900 + $42,560 + $56,000 = $422,960
The total tax due for this property is $422,960.
* The federal cap gains tax calculation is (tax rate) x (realized gain - depreciation recapture)
While depreciation recapture can create a hefty tax bill, investors can defer it along with capital gains taxes by utilizing a 1031 exchange. A 1031 exchange can be done into another property or a DST. Working with a tax specialist is the best way to know if a 1031 exchange is right for you.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Hypothetical examples shown are for illustrative purposes only.
Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
No public market currently exists, and one may never exist. DST programs are speculative and suitable only for Accredited Investors who do not anticipate a need for liquidity or can afford to lose their entire investment.
The income stream and depreciation schedule for any investment property may affect the property owner's income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
