What is Depreciation?
First things first - as it relates to tax, depreciation does not mean a decline in the property’s value. Rather, it refers to an allocation of a property’s cost over its “useful life”. Because physical assets, such as real estate, wear down over time, the IRS allows for income tax deductions to account for the loss of functionality.
Generally, the IRS allows residential real estate (excluding the land portion) to depreciate on a straight-line basis over 27.5 years. Likewise, commercial property, excluding land, may be depreciated over 39 years. For instance, if a commercial property was purchased for $1,000,000, with $200,000 attributable to land value, then the investor may claim an annual depreciation allowance of $20,513 ($800,000 / 39 years).
How Does Depreciation Affect Real Estate Investments?
One of the greatest benefits of investing in real estate is the tax-efficient nature of its cash flow. Just as the interest portion of a mortgage payment may be deducted from taxable income, so can the depreciation allowance. Even better, depreciation allowance is a “paper” deduction, meaning an investor may not necessarily incur an out-of-pocket expense in order to reduce taxable income.
Continuing with the above example, let’s assume the investment is debt-free, produces annual cash flow of $50,000 and the investor’s marginal tax rate is 40.0%. Without the depreciation allowance, the investor would owe $20,000 in income tax (40.0% of $50,000) resulting in $30,000 of after-tax cash flow. However, by utilizing the depreciation allowance of $20,513, the investor is only taxed on $29,487, resulting in $11,795 of income tax and $38,205 in after-tax cash flow. By utilizing the depreciation allowance, the investor’s after-tax cash flow increases by over 27%!
What is Depreciation Recapture?
Now the bad news. When an investment property is sold, to the extent the investor took depreciation allowances, the IRS charges a tax, known as depreciation recapture which is equal to 25% of the aggregate depreciation allowance taken over the investment holding period.
Using our same example, if the investor held the property for 5 years and utilized $102,565 of depreciation allowances (5 years times $20,513 per year), then they would be facing a $25,641 depreciation recapture tax upon sale. What’s worse - this tax is in addition to federal capital gains tax, state capital gains tax and potentially medicare surtax. Though federal capital gains may be partially or fully offset by depreciation recapture charges, when it’s all accounted for, an investor could very well be facing taxes of 30% to 40% of their gains!
Is There a Solution to Depreciation Recapture Tax?
Yes! Fortunately, by utilizing another part of the tax code, and conducting a 1031 exchange, investors can defer all depreciation recapture and all capital gains taxes.