When a real estate investor sells a property, they have the potential to be liable for up to three different types of tax: capital gains tax, net investment income tax, and depreciation recapture tax. All three can impact the profitability of a transaction and investors are well served to pursue strategies to actively minimize them.
In this article, readers will learn what depreciation recapture is, how the taxes associated with it can be reduced using a 1031 Exchange, and the basic rules that must be followed to ensure the 1031 Exchange is executed properly.
At First National Realty Partners, we have a tremendous amount of experience working with investors to facilitate 1031 Exchanges. To learn more about our current investment offerings, click here.
What is Depreciation Recapture?
Real estate is an asset whose physical condition degrades over time. For example, air conditioning systems can wear out or the constant wear and tear of commercial use can ruin carpet, paint, and other finishes. To account for this, IRS accounting rules allow investment property owners to expense a portion of the asset’s value each year in a process known as depreciation.
On a year to year basis, this expense reduces the property’s tax liability. But, this same depreciation “accumulates” over a multi-year period and the resulting reduction in a property’s “tax basis” usually means that there is a big difference between it and the sale price. This is where depreciation recapture comes into play.
When a property is sold, the depreciation that accumulated over its holding period is “recaptured” and taxed. For investors who aren’t prepared, the tax bill can come as a big surprise.
Calculating The Taxes Due
To understand the impact of depreciation recapture taxes, an example is helpful. To make this point, special attention should be paid to three dollar amounts in a purchase and sale:
- Purchase Price: The purchase price of the property sets the initial tax basis for the property. For example, if a property is purchased for $1,000,000, this is the initial cost basis from which depreciation is subtracted.
- Accumulated Depreciation: As described above, depreciation is the amount of money that is expensed each year and it reduces the cost basis by a similar amount. Over many years, the amount of accumulated depreciation can reduce the cost basis by a large amount. IRS rules limit the amount of depreciation that can be taken each year. For example, if an owner expensed $10,000 in depreciation for five years, the total accumulated depreciation at the time of sale would be $50,000.
- Sale Price: The sale price is the price that a property is sold for. The difference between the sales price and the adjusted cost basis at the time of sale is what determines the amount of depreciation recapture.
With these three amounts in mind, there are two scenarios that investors may encounter with regard to depreciation recapture and capital gains. They are taxed differently.
To set up this example, suppose an investor purchases a property for $1,000,000. Over 5 years, they take $250,000 in depreciation, which means the adjusted basis is $750,000 ($1,000,000 – $250,000).
NOTE: The example below is for illustrative purposes only. Every situation is unique and the actual taxes may be different than those described. It is always a best practice to work with a CPA to ensure taxes are calculated correctly.
Scenario #1: Capital Gains Are More Than Accumulated Depreciation
The difference between the sales price and the adjusted basis is a taxable gain and it is treated differently than the taxes on depreciation recapture. Suppose that the above property sold for $1,260,000. This means that there is a gain of $510,000, which is more than the total accumulated depreciation of $250,000.
Depreciation recapture is taxed as ordinary income. Assuming the highest tax rate of 37%, the tax due on the $250,000 of depreciation recapture in the example above is $92,500 ($250,000 * 37%).
Long term capital gains for properties held more than one year are taxed at a lower rate than depreciation. As of this writing, the top capital gains tax rate is 20%. Because the remaining gain is $260,000, the investor would owe $260,000 multiplied by 20% or $52,000 in capital gains taxes.
In this scenario, the total tax bill is $144,500.
Scenario #2: Capital Gains Are Less Than Accumulated Depreciation
Now, assume the same $1,000,000 purchase price and $250,000 in accumulated depreciation. But, in this scenario, assume a sales price of $490,000, which results in a loss of $260,000 ($490,000 sales price minus $750,000 cost basis).
Because the loss of $260,000 is more than accumulated depreciation of $250,000, there is no depreciation recapture tax. In addition, the taxpayer would not be required to pay capital gains taxes because the property sold for less than its adjusted basis. In fact, the loss creates three options with regard to the filing of the tax return:
- It can be used to offset tax liabilities in the current year
- It can be “carried back” to reduce taxes in the previous two years
- It can be “carried forward” to reduce tax liabilities in future years.
In scenario #1, the taxes due can be deferred by entering into a 1031 Exchange transaction.
How to Defer Depreciation Recapture With a 1031 Exchange
Fortunately, investors can defer both depreciation recapture and capital gains taxes by utilizing a type of transaction known as a 1031 Exchange. In it, investors can defer taxes on the profitable sale of a rental property – the relinquished property – by reinvesting the sale proceeds into a new property, known as the replacement property, as long as it is “like kind.”
This is a complicated transaction and investors must abide by a series of 1031 rules defined by the IRS to ensure full tax deferral. For example, depreciation recapture can be avoided as long as one building is swapped for another. However, if improved land with a building is exchanged for unimproved land without a building, the depreciation claimed on the building will be taxed as ordinary income. This type of complexity underscores the need for investors to work with a qualified intermediary and/or lawyer or CPA with 1031 Exchange expertise to help navigate the rules.
Conclusions & Summary
Because its condition degrades over time, internal revenue code (IRC) rules allow real estate owners to expense a portion of the property’s value each year in a process known as depreciation. Over a long time period, these annual depreciation deductions accumulate and are subtracted from the property’s purchase price to determine its cost basis.
When the property is sold, this accumulated depreciation is “recaptured” and it becomes classified as taxable income. The exact tax consequences depend on the property’s sale price, the owner’s tax bracket, and the difference between the cost basis and the sales price. If the total amount of accumulated depreciation is large, the tax bill can be equally sizable.
Fortunately, investors can defer depreciation recapture by engaging in a 1031 property exchange, also called a like kind exchange. In this transaction, investors can defer taxes on the sale of real property as long as they use the sales proceeds to purchase another like-kind property.
The specific rules of a 1031 Exchange are outlined in section 1031 of the internal revenue code, but they can be complex. For this reason, it is a best practice for investors to work with a CPA, tax attorney, and/or qualified intermediary to help them navigate the specific requirements of a 1031 Exchange and the complexities of tax law.
Interested In Learning More?
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