Is Depreciation Recapture Subject to Net Income Investment Tax?

Posted Nov 10, 2021

How Much Mortgage is Tax Dedictible

Selling a rental property for a gain often means the investment was a success. However, as is usually the case, the IRS will take notice and want a piece of the action. In addition to taxes on capital gains, investors may owe depreciation recapture and net income investment taxes.

How do these two taxes work, and how does an investor know when they’ll owe them?


What Is Depreciation Recapture?

Depreciation recapture is the IRS’s way of clawing back some depreciation expenses taken while holding an investment property. Depreciation recapture only occurs when the property is sold.

Investors deduct depreciation expenses each year they hold rental property. The IRS allows the depreciation expense deduction because buildings degrade with each year. The depreciation expense helps to offset the physical degradation.

However, once an investor sells their property, they’ll have to give back some of the depreciation expense taken over the lifetime of the holding. Depreciation recapture is capped at 25%. This means if an investor took $50,000 in total depreciation, $12,500 would be owed as depreciation recapture.

The depreciation recapture tax is independent of any capital gains taxes that are owed. Although for gains, depreciation will affect the cost basis, which in turn affects the gain. To see the differences, let’s look at an example:

 

$1,000,000 — Purchase price

$400,000 — Total depreciation

= $600,000 — Adjusted basis

 

$2,500,000 — Sale price

$1,900,000 — Gain (2,500,000 - 600,000)

 

$150,000 — Depreciation recapture (.25 x 600,000)

$380,000 — Long-term capital gain taxes ($1,900,000 x .20)

 

Taxes owed in this case are $530,000. The investor may still owe NIIT, which we’ll cover in the next section.

If the gain had been less than the total depreciation, the depreciation recapture rate would have applied to the entire gain. For example, a $300,000 gain, less than the $400,000 total depreciation, would have been taxed at 25%. There would have been no long-term capital gains tax.

Investors can defer depreciation recapture by utilizing a 1031 exchange. Not only does a 1031 exchange defer capital gains taxes, but it also defers depreciation recapture.

What Is Net Income Investment Tax?

The net income investment tax (NIIT) is a 3.8% tax applied to rental property income and capital gains once certain income thresholds are met, depending on your filing status. 

For example, an investor who is married filing jointly needs a MAGI (marginal adjusted gross income) of $250,000 before the NIIT will kick in. During the year, the investor made $190,000 from rental income, which is below the threshold. However, they also have a job that pays $70,000, putting their MAGI at $260,000. They will owe $380 (.038 x 10,000) in NIIT on the $10,000 of income, which is the amount over the $250,000 threshold.

Depreciation Recapture And Net Income Investment Tax

The NIIT is a tax charged against income exceeding a certain threshold. Depreciation recapture is a tax on gains from the sale of an investment property. The two are independent. NIIT is not a tax on depreciation recapture since they are both taxes. 

If you meet the criteria to be considered a real estate professional for tax purposes, NIIT does not apply.

 

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. 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. Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. 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. Examples shown are hypothetical and for illustrative purposes only.

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