For real estate investors, annual depreciation expense is one of the main draws for real estate investing. It’s sometimes called a phantom expense because investors pay no out-of-pocket expense. But the expense’s effect is real — potentially lowering an investor’s tax bill.
While depreciation is a great benefit when owning a property, if an investor decides to sell that property at some point in the future, they’ll find that Uncle Sam wants some of their depreciation money back. Let’s see what happens to depreciation when a rental property is sold.
The tax code says that a building will not last forever. In fact, it will last 27.5 years (39 for commercial property). This number is just a way to depreciate the value of the building each year.
Let’s walk through an example of how depreciation works. An investor buys a property for $500,000. Each year, the investor can deduct ~$18,181 in depreciation. We get that number by dividing $500,000 by 27.5 (not including the value of the land). Or, you can multiply the purchase price by 3.64% (1/27.5).
An annual depreciation expense doesn’t affect an investor’s cash flow. But it still has the potential to decrease the investor’s annual tax bill, which is what you’d expect from an expense. However, what the IRS giveth, they also taketh away.
When it comes time to sell the property, the IRS will want some of that depreciation back. This is called depreciation recapture. Depreciation recapture will occur at the time of sale whether the investor took depreciation or not.
Depreciation recapture recognizes as income what the investor deducted as depreciation while owning the property. While the annual depreciation might have seemed like a 100% tax break, that wasn’t the case. The investor must pay back part of the depreciation taken while owning the property.
The good news (for high-income earners) is that depreciation recapture is not taxed at the regular income tax rate. Instead, it is capped at 25%.
The best way to see how depreciation recapture works is to look at an example. Let’s say an investor purchases a $500,000 rental property, holds it for five years, and then sells it for $700,00. Breaking it down, we have:
Holding Period: 5 years
Depreciation: 5 x $18,181 = $90,905
Cost Basis: $500,000 - $90,905 = $409,095
Profit: $700,000 - $409,095 = $290,905
Note that closing costs and improvements have been ignored. We can see from this example that depreciation increased the investor’s profit. Running the taxes on this example:
Using a long-term capital gains rate of 20% (high-income earner):
20% x $200,000 = $40,000
$200,000 comes from gain minus depreciation ($700,000 - $500,000). Now we take depreciation recapture:
25% x $90,905 = $22,726
Total tax bill: $62,726
The depreciation recapture tax is paid to the federal government. Of course, the actual tax rates will vary by income. Some investors may also be hit with a Medicare surcharge tax of 3.8%.
The above is the amount that the investor will owe if they sell the property outright. But there may be a better option for the investor.
Selling a rental property can generate a hefty tax bill. There is a way to defer those taxes. A 1031 exchange can push your tax bill well out into the future. Investors can defer their tax bill by exchanging property for a like-kind property instead of selling it.
Depreciation recapture is an additional tax that is owed when a rental property is sold. The tax is applied to reclaim (by the IRS) some of the depreciation tax breaks taken while owning the property. For some investors, this may generate a larger tax bill than was anticipated. However, by utilizing a 1031 exchange, investors can kick the bucket down the road on their taxes.
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. 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. Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. Hypothetical examples are for illustrative purposes only.