Real estate can provide investors with value from multiple sources. Well-positioned properties can strive to provide consistent cash flow from operations, in addition to appreciation in the property’s intrinsic value. And, if you are a real estate investor, you could access this property value appreciation, either via a sale of the asset or a refinance of debt obligations.
However, when that real estate is sold, you could be liable for taxes on the gains, similar to other investments. This liability, known as capital gains tax, is calculated as a percentage of the difference between the purchase price of the property and its sale price.
And, unlike other investment classes, real estate investors are able to deduct the value of the physical depreciation from their capital gains basis. Capital gains tax for real estate is the net appreciation in value -- accounting for the appreciation in the property’s value -- less the physical depreciation that has occurred over that period.
In other words, welcome to the world of depreciation recapture.
All about depreciation -- and how it’s recaptured
To understand depreciation recapture, it makes sense to understand depreciation. And, to understand depreciation, it makes sense to understand that physical things -- such as real estate – become less valuable over time, due to physical deterioration and obsolescence.
To account for this depreciation of value, the IRS allows you to reduce the property’s capital gains tax liability. Basically, upon the property’s sale, you can deduct a specified dollar amount from the capital gains basis, for each year the investment was held.
In other words, you can spread the costs incurred in buying and improving your property (not including the land, which is not depreciable), over the asset’s useful life period. According to the IRS, the definition of “useful life” is 27.5 years for residential properties, and 39 years for commercial properties.
The IRS allows you to depreciate a rental property under the following conditions.
- You own the asset (even if you are paying off a mortgage).
- You use the asset either as part of your business or as a rental property.
- That the asset has a determined useful life; it can wear out or loses value.
- The asset must be held for at least one year. If you buy a rental property in January and decide to sell it in December, you won’t be able to write off any depreciation against their capital gains tax liability.
Depreciation is a great tool for decreasing tax liability, especially with a long-term holding period. For example, if you buy a duplex for $300,000 and put an additional $50,000 into it for improvements, your total cost basis is $350,000. Due to the fact that land is non-depreciable, you can’t use it to determine your depreciable basis. For this example, if we assume the value of the land is $75,000, your depreciable basis is $275,000 ($350,000-$75,000).
Assuming that the property is put into service immediately after you buy it, you can divide that $275,000 by its useful life of 27.5 years, giving you a depreciation value of $10,000 per year. Upon a profitable sale of the property, however, the IRS will want that money back.
Let’s say that, after 10 years of being a landlord for the above-mentioned property, you want to get rid of it. You sell it for $500,000, meaning you receive a tidy profit of $150,000. But with depreciation recapture, you need to consider the following:
- Your depreciation during that 10-year hold will be $100,000 ($10,000 x 10 years).
- Your adjusted basis in the property will total $250,000 ($350,000-$100,000)
- When you sell that asset for $500,000, your total gain will be $250,000 (the sales price of $500,000 less the adjusted basis of $250,000).
So how are taxes assessed? Assuming you are in the highest tax bracket, the portion of the gain attributable to a property value increase will be taxed at 20%. In this example, that would be $150,000 ($500,000 - $350,000). As mentioned earlier, the IRS will want to recapture any depreciation that was taken, which would be $100,000 taxed at a 25% tax rate. When the tax dust settles, this means you’ll owe $55,000 on a $500,000 sale. This figure could increase if state taxes and the Section 1411 Medicare Surtax are applicable.
If your head is reeling from the above, your first thought might be: “I just won’t depreciate my rental home or shopping center. Then I can avoid depreciation recapture.” This could make sense theoretically. However, the IRS already assumes you are taking that depreciation, whether you are doing so or not. As such, you’re significantly better off taking the depreciation while you own that property, and reducing your taxable income during your hold period.
Exchange to avoid recapture
Another way to avoid depreciation recapture is by selling the property for less than its book value, which wouldn’t make much sense. Another solution is to hold onto the asset until you die. When that duplex becomes part of your estate, the cost basis is reset to the market value, meaning depreciation recapture will not be triggered.
Or, if you want to dispose of the asset in your lifetime, and without the huge tax bite, you could place the proceeds of that asset’s sale into a like-kind property, through a 1031 exchange.
We’ve written extensively about the U.S. Code § 1031: “Exchange of real property held for productive use or investment.” An exchange into a physical property or a Delaware Statutory Trust (DST) can be helpful for deferring taxes on capital gains from the sale of assets. It can also be extremely helpful for avoiding depreciation recapture; gains are not recognized when the property is transferred into a DST or other like-kind asset. A non-recognized gain avoids the depreciation recapture trigger.
No such thing as free depreciation
Plenty of costs are incurred when it comes to owning income-producing real estate. Depreciation can be used to mitigate those costs by reducing taxable income, but it isn’t free. While depreciation recapture can take a bite out of your profits, it is also important to analyze how using it during your real estate ownership reduces your taxable income.
And, if you want to completely avoid depreciation recapture and capital gain taxes, an exchange into another property or DST can be a way to help defer taxes, while allowing you to re-invest proceeds. The best way to determine if this is the right move for you is to keep in mind what is best for your portfolio, as well as your overall investment goals and objectives.
For more information about using the 1031 exchange process with your real estate holdings, contact Realized Holdings at realized1031.com or by calling 877-797-1031.
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.
There is no guarantee that the investment objectives of any particular program will be achieved.
The actual amount and timing of distributions paid by programs is not guaranteed and may vary. There is no guarantee that investors will receive distributions or a return of their capital. These programs can give no assurance that they will be able to pay or maintain distributions, or that distributions will increase over time.
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