Depreciation recapture explained, what real estate investors and homeowners need to know about this.

by | Indy Anna, Real Estate Investing, Uncategorized

What is depreciation recapture?  How can I avoid paying these taxes?  What real estate investors and homeowners need to know about depreciation recapture.

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This is a quick video I made to answer a few questions about depreciation recapture.

Depreciation Recapture Explained.

How can I avoid paying depreciation recapture taxes?

Can you give a basic breakdown of depreciation recapture?

What’s the simplest way to understand depreciation recapture?

Can I figure this out myself, or do I need professional financial help?

What is depreciation recapture and what does it mean for homeowners and investors?

I’m not an attorney or CPA.

I am not a CPA or real estate attorney so this is ONLY to help you guys that have asked about this.  You know always been trying to learn and know what you don’t know and to get better questions to go to your finance professional with because we don’t recommend doing this on your own.

(unless you happen to be a professional.)

Each tax year your property is taking a loss on paper, but it is the structure alone and NOT the land.  The structure is also called the “improvement”.  To find out what that costs you’re going to take a look at your most recent appraisal.  Usually (again be careful because it is not always the case) it is an 80/20 ratio of structure to land.

So the home/building is 80% and the land is 20%.

So if your property is worth $100,000 then the house is worth $80,000 while the land is worth $20,000.

And to be clear, according to most finance professionals simply not claiming this depreciation (the loss on paper) each year so you don’t have to fuss with it later won’t work.  The IRS assumes you are taking advantage of this and it won’t turn out on the backend as you may hope because you’ll still have to pay the taxes.

The lesson here is the IRS thinks you’re depreciating on paper, even if you haven’t been.  So that’s one point to get with your professional on right away.

Why are you taking a “loss” on paper?

Why do you get to show or get tax advantages for “losses” on paper?  This is because once a house is built it begins to break down from weather, wear and tear, etc.  The land doesn’t really get impacted this way. 

So the IRS is “paying you” to maintain the property’s condition.

Instead of writing off these expenses all at once the government gives you a deduction that is spread out over a number of years or what’s called “the useful life of the property”.  They have a formula to do that and the formula depends on your tax bracket and calculation method but a common number is 27.5 years.

27.5 years.

So if you take the cost of the improvement to the land (that is the cost of the house) and divide it by 27.5 you can write that off every year.  Dividing by 27 is also about the same as multiplying the value of the home by 3.636% so that is also another method used.

CHECK WITH YOUR accountant on this.

Dividing by 27.5 is about the same as 3.636%.

So that is the “depreciation”.

That makes sense right?

You have two things to consider.  First is the land and second is the house on it.  You can write off the cost of the HOUSE not the land and a normal number is if you take the cost of the house and divide it by 27.5 that’s how much you can write off every year.

What about the “recapture” part?

The ‘recapture’ portion of this is simple enough in theory.  This is the IRS  ‘recapturing’ taxes on a profitable sale based on what the taxpayer previously offset (by means of depreciation) in taxable income.

This comes into play when the property is sold. 

This gets more complex with real estate as the value often increases over the years and doesn’t lose value.  This means that you may need to pay back what you didn’t pay when you were depreciating.  This is also another point to take up with your savvy trusted finance professional that you’ve built a solid relationship with.

Know your tax bracket. 

You could be anywhere from 0% tax bracket (active deployed military/other military) or 10%, 15%, 25% or more.  You want to get clear on this with your financial professional.

Here’s another consideration…

How long have you held property? 

When you sell the rental property the IRS comes back and wants to tax you on the deductions that you took over the entire time you owned the property.

So here’s a basic example:

Let’s say you buy a property for $200,000 and your accountant already broke up that price so X is the value of the land and Y is the value of the home built on it.  Now we’ll say that every year you write off $7,000 and after 10 years you go to sell the property for $300,000.

Since you bought for $200,000 and you sold for $300,000 you made $100,000.

You will have to pay a capital gains taxes on that $100,000, BUT the IRS says you actually made more than just $100,000 because you wrote off $70,000 over that 10 years of $7,000 a year.

So the $200,000 price you paid comes down to $130,000.

This means you made $100,000 that is subject to a capital gains tax rate which may be 15% for example if you are in the 32% income tax bracket.  In addition to that you also have to pay taxes on the $70,000 that you wrote off.

Th depreciation tax could be as much as 25%.

So you could owe an extra $17,500 (25% of 70k) in taxes on the sale.

Now if you take the L (loss) on the sale, there is no deprecation recapture. 

The other solution/option is doing a 1031 like kind exchange which is going to delay your depreciation recapture.  There are other classes on 1031 exchanges that I’ve made already for you guys, be sure to check them out and learn more about your best  potential financial outcomes and….

Make the universe SMILE.  = )

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