The IRS provides a nice tax benefit through annual depreciation for real estate investors. But as you might expect, what the IRS giveth, it also taketh away. This is also true for the depreciation deduction, but not immediately. You can continue taking the depreciation while owning the property, but once you decide to sell, the IRS will come knocking. In this article, we go through what depreciation is and how to calculate the corresponding depreciation recapture that is incurred at the time of sale.
What is depreciation?
Depreciation can reduce income taxes — you write off depreciation to reduce your taxable income each year. This is known as depreciation expense and is allowed by the IRS. Depreciation expense can be taken each year that the investor owns the property. Depreciation expense is also called a phantom expense because there isn’t any out of pocket cash going toward the expense.
The main benefit of depreciation is tax savings. The IRS allows taxpayers to write off the value of an investment property over time. This lets investors take a depreciation deduction annually. Another advantage is that there is no out of pocket expense with depreciation, unlike many other expenses.
Depreciation is taken on property improvements — anything built on the land, but not the land itself. To determine the amount of depreciation that an investor can take annually, the IRS determines the rate at which investors can depreciate improvements (land is not depreciable). This rate is different for residential and commercial properties:
- Residential —27.5 years maximum and ~3.64% annually
- Commercial —39 years maximum and ~2.56% annually
Building content improvements can be depreciated during the first 5-7 years. This means that the depreciation expense is higher in the first few years of the investment. To get the most accurate analysis for commercial real estate depreciation, a cost segregation study should be performed. While hiring a consultant or CPA to complete the study is expensive, the investor may be able to claim more (than just the study’s expense) through segregated depreciation.
Although the investor benefits from depreciation while holding investment property, the IRS will reclaim some of the taxes that were written off. This is done through depreciation recapture when the property is sold.
How to Calculate Depreciation Recapture
There are a couple of steps in calculating depreciation recapture. We’ll use a $1 million property with $500,000 in initial equity for a couple living in Texas who are married filing jointly. Their capital gain tax rate is 20%, and their Medicare surtax is 3.8%.
1.) First, calculate the adjusted tax basis:
Original Equity Interest: $500,000
Add: Mortgage Used to Purchase $0
Add: Closing and Transaction Costs $0
Add: Total Spent Improving/Repairing $0
Less: Depreciation Taken During Ownership ($250,000)
Less: Deferred Gain from Previous 1031(s) $0
Adjusted Tax Basis: $250,000
2.) Calculate the realized gain:
Selling Price of Relinquished Property $1,000,000
Less: Qualified Closing Expenses ($50,000)
Net Selling Price $950,000
Less: Adjusted Tax Basis ($250,000)
Less: Passive Activity Losses $0
Realized Gain (Loss) $700,000
3.) The depreciation recapture value is the amount of depreciation taken multiplied by a 25% rate:
25% x 250,000 = $62,500
To get the full tax picture and impact of depreciation recapture, let’s continue to the total capital gains tax due.
4.) The remaining gain is taxed at the capital gains rate of 0%, 15%, or 20%:
Federal Capital Gains Tax: 20.00% x $450,000 = $90,000 *
Section 1411 Medicare Surtax: 3.80% x $700,000 = $26,600
Effective State Capital Gains Rate: 0.00% x $700,000 = $0
$62,500 + $90,000 + $26,600 = $179,100
The total capital gains tax due for this property is $179,100.
* The federal cap gains tax calculation is (tax rate) x (realized gain - depreciation taken)
Depreciation expense can provide for some great tax savings while owning an investment property. Those savings may be too good to be true, and the IRS agrees. That’s why they claw back 25% of depreciation expenses through depreciation recapture. It’s important to be prepared for depreciation recapture when it comes time to sell your property. Working with your tax advisor can ensure you’re not caught off guard.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Example shown is hypothetical and for illustrative purposes only. Actual results may vary based on your individual situation. Not tax or legal advice, one should consult the appropriate professional regarding your individual circ*mstance.
Certainly! Here's a comprehensive breakdown:
Depreciation in Real Estate Investment:
What is Depreciation?
- Definition: Depreciation is an accounting method used to allocate the cost of an asset over its useful life. In real estate, it applies to property improvements, not the land itself.
- Tax Benefit: Reduces taxable income annually, known as depreciation expense, permitted by the IRS.
- No Cash Outlay: Referred to as a "phantom expense" because it doesn't involve actual cash expenditure.
Key Points:
- Tax Savings: Allows investors to write off the value of an investment property over time, reducing tax liability.
- Property Eligibility: Depreciation applies to improvements on the property, not the land.
- Residential vs. Commercial: Different depreciation rates apply: 27.5 years maximum (~3.64% annually) for residential and 39 years maximum (~2.56% annually) for commercial properties.
- Accelerated Depreciation: Certain improvements can be depreciated over 5-7 years, leading to higher depreciation expenses in the initial investment years.
- Cost Segregation Study: A costly yet beneficial study that can potentially increase claimed depreciation for commercial real estate by segregating assets.
Depreciation Recapture:
- Eventual Reclaim: IRS reclaims taxes saved via depreciation when the property is sold.
- Calculation: Involves determining the adjusted tax basis and realized gain.
Calculation Steps:
- Adjusted Tax Basis: Consider factors like original equity, mortgage, closing costs, improvements, and subtract depreciation taken.
- Realized Gain: Calculate selling price, deducting qualified expenses and adjusted tax basis.
- Depreciation Recapture: Multiply the amount of depreciation taken by a 25% rate to determine recapture value.
- Total Capital Gains Tax: Calculate the remaining gain taxed at various rates to determine the total tax due.
Conclusion:
- Importance of Preparation: Awareness and preparation for depreciation recapture when selling a property are crucial.
- Professional Advice: Working with tax advisors ensures readiness and understanding of potential tax implications.
This information emphasizes the intricacies of depreciation in real estate investments, highlighting both its benefits and the eventual recapture by the IRS upon property sale. The provided example illustrates the calculations involved in determining depreciation recapture and the subsequent total capital gains tax due, emphasizing the importance of seeking individualized professional advice.
