Owning real estate as an investment can generate certain benefits. There is the potential for cash flow and valuation increase. There can also be certain tax benefits to help offset income. Among these likely benefits is depreciation recapture. But given its purpose with real estate, is depreciation recapture ordinary income?
The answer here is yes and no. Depreciation recapture is taxed as ordinary income. But they aren’t the same things.
To understand depreciation recapture, it’s essential to understand depreciation. And to understand depreciation, it’s essential to understand the IRS viewpoint. Mainly, all tangible or physical assets have a useful life. Furthermore, during that useful life, wear, tear, and obsolescence can decrease the value of an asset over time.
The IRS allows you to deduct the cost of depreciation over the useful life of your investment real estate (27.5 years for residential properties and 39 years for commercial assets). But that deduction comes with strings attached. When you sell that real estate, the IRS gets those deductions back by levying a maximum 25% tax on the gain of the sale (depending on your ordinary income tax bracket). This is what’s known as a depreciation recapture tax.
Ordinary income represents what’s earned from selling goods or services. Ordinary income consists of wages, salaries, commissions, and interest income from investments. As a real estate investor, it’s essential to understand that the IRS views rental income from your property as ordinary income. This means it’s taxed in accordance with your particular tax bracket. Regardless of the source, ordinary income is taxed during the year it’s earned.
It’s possible to use your depreciation expense to offset that rental income. However, depreciation expenses can’t be used to offset earnings from salaries or wages.
To summarize, depreciation and ordinary income aren’t the same things. Both are taxable items but under different situations. Regarding your tax situation, it’s a good idea to consult a qualified professional who can help you determine what taxes are owed.