Depreciation recapture for real estate investors.;
Depreciation recapture is the ‘recapture’ of some of the depreciated (and written off) value of a property for tax purposes. So your write if off and then a portion of benefit you received is later “recaptured” or taken back.
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Let’s define it recapture:
Depreciation recapture is going to happen during the tax year that an income property is sold, if and when the sales price is greater than the tax basis or adjusted cost basis (basically the original cost of the property minus the depreciation).
What does that mean?
When you improve land, those improvements generally wear down over time. So the house that is built on land is considered and improvement to the land, but that house or any building is going to deteriorate through normal wear and tear over time. So the government will allow you to take the loss in value of the house (or any asset) and divide the cost over a number of years. One example is 27.5 years.
That is how depreciation works, and I explained depreciation in this video here.
So by using depreciation you lower the amount that you can be taxed, you take the house and create what is called an adjusted cost basis or a tax basis that is lower than the actual value of the home. Make sense?
Now if you sell the house, and it sells for a price higher than that adjusted cost basis, then that difference will be treated and taxed like regular income.
Basically you are able to defer the taxes, not avoid them.
Putting the definition to use.
Example: Let’s say you purchased a property for $220K. If the annual deprecation was $10K, and you sold it after 5 years, that’s $220K – $50K ($10K x 5 years) = $170K as the adjusted gross basis.
Now let’s say you sold this property for $300K. The realized gain on this would be
$300K – $50K = $250K. The capital gain would be $250K minus the $50K (depreciation) = $200K.
That would mean…
If the capital gains tax is 15%, and you fall into the 28% income tax bracket then the total amount in taxes due on this property is .15 x $200K (capital gain) = $30K + .28 x $50K (depreciation) = $14K, and the recapture amount is $14K.
$14,000 would be ‘recaptured’ by the IRS in taxes on this property.
Also realize that whether you take or claim depreciation or not you can still get hit with recapture and having to pay. The terms the IRS use is “allowed” versus “allowable”, so even if you do NOT write off depreciation you can still be held liable for recapture amounts.
How to avoid depreciation recapture…
Using a 1031 exchange, and making a like kind transfer of properties is the most common way to avoid this. We’ve covered a couple of lessons on 1031 exchanges, be sure to check them out. Yes, in one I say “1301” but other than that, worth checking out (Honest mistake!)
Here is a breakdown of the 2019 tax brackets and that they mean for you:
https://taxfoundation.org/2019-tax-brackets/ (2019 tax brackets)
Here are two wikipedia articles on taxes and tax brackets:
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