Investment property owners are likely quite familiar with depreciation, since it allows them to deduct certain costs associated with acquiring and improving income-producing real estate, which can lead to lower annual taxable income.
Real property investors can take advantage of a host of tax write offs, including property taxes, mortgage, and some other forms of insurance, maintenance and repair costs, marketing and travel expenses, and professional services related to the management and upkeep of rental properties. Depreciation adds another important tool to your tax planning strategies. Residential rental properties can be depreciated over a 27.5-year timeframe, while commercial properties can be depreciated over 39 years of useful life.
There’s an end to the benefits associated with depreciation, though. At some point, the IRS will require an accounting and taxation of any depreciation deductions claimed while you held the asset.
Let’s take a look at what triggers depreciation recapture.
If you divest an income-producing rental property for a loss, you won’t have to worry about paying taxes on any depreciation recapture you claimed while you held the asset. You’ll get a pass due to your capital losses.
However, anytime you sell a rental property and realize a gain above your cost-adjusted basis, you’ll have to pay taxes on the amount you claimed through depreciation. This tax is called depreciation recapture. In the eyes of the IRS, you benefited financially from asset appreciation when you netted a capital gain, so you’ll have to pay back a portion of the depreciation you claimed – you don’t get to double-dip by claiming a tax break and then profiting from asset appreciation.
If you held the property for a year or longer before selling it for a profit, you’ll pay taxes on any realized gains at long-term capital gains rates of 0, 15, or 20 percent depending on your filing status and income. Depreciation recapture is taxed at a higher rate, though, and here’s why.
The annual depreciation dedication offsets ordinary income. If you purchase a rental home and immediately place it into service, you can begin deducting 3.636 percent of the asset’s cost basis (3.636 percent is 100 percent broken down over the useful lifespan of 27.5 years) from your taxable income. The total amount you claimed through depreciation, therefore, is taxed at your nominal tax rate rather than the more favorable capital gains rate. However, the maximum tax rate for depreciation recapture is currently capped at 25 percent for 2022.
Depreciation is an important tax break for investment property owners because it allows them to spread out acquisition, maintenance, and repair costs over time. The depreciation tax deduction also offsets ordinary income, which can lead to reduced tax liabilities.
Depreciation recapture is triggered when you sell a rental property for a gain. If you lose money in the deal, you won’t have to pay back any of your depreciation deductions. If you netted a gain, though, you’ll have to pay taxes on the accumulated depreciation at your nominal tax rate, with a cap of 25 percent.
A licensed tax professional can help you determine your adjusted cost basis in a rental property, and your potential tax liability through depreciation recapture. Investors who face significant capital gains and depreciation recapture taxes after selling investment properties may want to consider completing a 1031 exchange in order to defer their tax liabilities.