You might have decided to invest in real estate for a few reasons. In some cases, rental property can be a hedge against inflation. That property could generate a steady cash flow for you. And, in some cases, that property might increase in value, giving you a potentially decent profit when you sell it.
Another likely benefit of rental real estate ownership is the possible deductions you can take. One of these involves depreciation costs. While depreciation can be an advantage in rental real estate ownership, what happens if you sell that depreciated rental property?
One possibility is you’ll end up with capital gains. But you’ll definitely be facing depreciation recapture, which you’ll owe to the IRS.
Let’s first examine the concept of depreciation. The assumption involving depreciation is that your rental property has a limited useful life. In other words, it will eventually wear out.
With this in mind, the IRS gives you the chance to divide the costs you incur in the purchase and improvements of that rental property across a certain time period, or its useful life.
How long is that period of time? For a residential property, the useful life is 27.5 years. For commercial properties, you’re looking at 39 years of useful life. This means that if you paid $750,000 for a residential rental property and incurred an additional $25,000 in capital costs to improve it, here’s how a depreciation deduction would work out:
$750,000 (purchase price) + $25,000 (capital improvement) = $775,000
$775,000 (total expenses)/27.5 years = $28,181.18
This means you can deduct $28,181.18 in depreciation costs against any income earned.
There are a few caveats, however. That rental property can’t be for personal use. Also, that property can’t be land (as land doesn’t wear out like buildings do). Otherwise, you can use that depreciation to help offset any income that might be taxed.
Whether you take that depreciation or not, once you sell that depreciation rental property, you’ll run into a depreciation recapture tax. That amount is 25% of the overall depreciation the property might have generated. If, for example, you owned the above property for 10 years. Here’s how the depreciation recapture might look:
$28,181.18 (annual depreciation) x 10 years (ownership) = $281,811.18
$281,811.18 (total depreciation during ownership) x 25% (depreciation recapture) = $70,452,95
So you would pay $70,452.95 to the IRS in depreciation recapture costs.
Incidentally, this doesn’t count other expenses involved with your sale, which includes federal capital gains taxes or any additional capital gains tax required by the state in which the property is located.
While the depreciation recapture tax might seem to be a little excessive, keep in mind that you were able to deduct more than $281,000 against your taxable income while you owned that rental property.
If you really don’t want to pay that depreciation recapture immediately (and are also shying away from paying your capital gains taxes as well), one possible solution is to exchange that rental property into another through a 1031 exchange. When done properly, the like-kind exchange can help defer both capital gains taxes and any depreciation recapture owed.