By: John Ruggieri
What is depreciation recapture?
When discussing the tax implications of selling real estate, one needs to also be aware of various issues to make an informed decision. One such aspect is depreciation recapture. Depreciation recapture is the portion of gain that is attributable to the depreciation deduction previously taken by the taxpayer. Depreciation recapture happens when a depreciable asset is sold, and the sale price exceeds the tax or adjusted cost basis. Some of the most common examples are rental properties and equipment that are sold for gains after they have been depreciated.
Ordinary income is taxed at a different rate than capital gains tax rate. For most taxpayers ordinary income is their wages, rents, and any short-term capital gains. These are taxed at a variable rate depending on your income such as 10%, 12%, 22%, 24%, 32%, 35% and 37%. Depreciation recapture is a taxed at a fixed 25% on the portion of the gain that is attributable to prior depreciation. Meanwhile, the highest capital gain tax rate is 20% for taxpayers in the highest bracket. Some taxpayers can even have a 0% tax rate, if they make under $40,400 and are single or, $80,800 if married filing jointly.
Let’s see an example of depreciation recapture:
- Purchase price of the property is $1,000,000
- Depreciation deductions claimed in the last five years: $100,000
- Sale price in year six: $1,200,000
- Depreciation recapture tax rate: 25%
- Capital gains tax rate: 15%
The adjusted cost basis here would be: $900,000 ($1,000,000 – $100,000)
The gain from the sale will be the sales price less the adjusted cost basis: $300,000 ($1,200,000 – $900,000)
The first $100,000 of the gain will be subject to depreciation recapture of 25%.
The $200,000 leftover will then be subject to capital gains tax rate of 15%.
How do you avoid depreciation recapture on a rental property?
There are not many ways the taxpayer can avoid paying depreciation recapture. Taxpayers however can elect into a 1031 exchange. A 1031 exchange is when an investor elects to have their proceeds from a real estate transaction used in their cost basis for a new property. This allows the investor to avoid capital gains and depreciation recapture in the short term. There are however many rules that investors must understand. These rules include, “a swap of properties thar are for business or investment purposes” i.e., rental properties. The property also must be considered like in kind, meaning that the new property for the investor must be similar to the old property. Additionally, the new asset must be purchased within 180 days. When electing a 1031 exchange be sure to have accurate record keeping as the IRS has very strict rules and regulations.
Each state also has different rules regarding 1031 exchanges. For example, New Jersey recognizes 1031 exchanges and will allow the taxpayer to make this election. If you are a Pennsylvania resident on the other hand, you will not be allowed to have a 1031 exchange due to Pennsylvania not recognizing them.
How long do you have to do a 1031 Exchange?
How long you have to do a 1031 exchange depends on what 1031 exchange the taxpayer chooses. There are four types of exchanges: simultaneous exchange, delayed 1031 exchange, reverse exchange, and a construction or improvement exchange. In a simultaneous exchange you must purchase or receive the new property at the same time as the one being sold by the taxpayer. In a delayed 1031 exchange the taxpayer has 45 days to identify a new rental/investment property and 180 days to finish the sale of their old property. This is also the most commonly used 1031 exchange. In a reverse exchange the taxpayer must pay in all cash. Additionally, in a reverse exchange the taxpayer has 45 days to sell their old investment/rental property and then has 180 days, including the first 45 days to sell their old property, to complete the sale of a new rental/investment property. Lastly, in a construction and improvement 1031 exchange the entire sale proceeds must be used to make improvements or as a down payment for the new rental/investment property. Furthermore, the new property must be equal or higher in value.
As with any tax planning or transaction, we highly recommend you consult with your CPA or accountant. Please feel free to contact us to understand the implications of depreciation recapture and its overall impact on deciding whether or not to sell real estate or equipment.