Last updated on December 16, 2021
Many business and investment assets such as rental property can be depreciated for tax purposes to reduce taxable income. However, when an investment is sold, the depreciation must be recaptured and then taxed.
In this article, we’ll discuss how depreciation and rental property depreciation recapture work, and how you can avoid paying tax when you sell an income-producing property.
What is rental property depreciation recapture?
Depreciation recapture occurs when a rental property is sold. Recapturing depreciation is the process the IRS uses to collect taxes on the gain you’ve made from your income property and to recover the benefits you received by using the depreciation expense to reduce your taxable income.
Understanding rental property depreciation
Before we discuss the recapture of depreciation for a rental property, let’s quickly review how and why depreciation occurs in the first place.
One of the biggest benefits of investing in real estate is that the IRS allows you to depreciate the property for each year of ownership, up to 27.5 years for residential rental property. The Internal Revenue Service assumes the property – but not the land - wears out or depreciates over time, and that depreciation expense is used to offset taxable net income.
Using depreciation to reduce NOI
For example, if you paid $120,000 for a rental property and the value of the lot is $20,000, you have a depreciation expense of about $3,636 per year:
- $100,000 property value (excluding the lot) / 27.5 years = $3,636 annual depreciation expense
You can then use the annual depreciation expense to reduce your taxable net income. If your NOI is $6,000 per year your taxable income is reduced to $2,364 thanks to the power of depreciation:
- $6,000 NOI - $3,636 depreciation expense = $2,364 taxable income
However, what the IRS gives they also take back when you sell the property by recapturing the depreciation.
How rental property depreciation recapture works
In addition to lowering your taxable income, depreciation also reduces or adjusts the cost basis of your property. After 10 years of ownership the property adjusted cost basis is:
- $100,000 original cost basis - $36,360 depreciation ($3,636 x 10 years) = $63,640 adjusted cost basis
Thanks to your great local property manager the rental property has generated consistently strong cash flow from qualified tenants. Another investor offers to buy your property for $240,000 – double what you paid for it 10 years ago.
When you sell, the IRS recaptures your depreciation by requiring you to use your adjusted costs basis for calculating your gain on sale instead of your original purchase price:
- $240,000 property sales price - $63,640 adjusted cost basis = $176,360 recognized gain
If your total income is $225,000 per year, your ordinary tax rate is 24% and your long-term capital gains tax rate is 15% (based on the 2020 tax tables for married filing jointly). It would be nice to have your total recognized gain of $176,360 taxed at the lower capital gains tax rate.
But, the IRS isn’t that nice. Instead, you’ll be taxed at your higher ordinary tax rate of 24% for the depreciation deductions you’ve taken of the past 10 years, with the rest of your gain taxed at the lower capital gains tax rate:
- Total recognized gain = $176,360
- Depreciation expense = $36,360 x 24% ordinary tax rate = $8,726 tax based on income bracket
- Remaining gain = $176,360 – $36,360 depreciation expense = $140,000 x 15% = $21,000 tax based on capital gains
- Total tax owed = $8,726 ordinary income tax + $21,000 capital gain tax = $29,726 total tax
What happens if your gain is less than the depreciation expense?
If your total recognized gain is less than your depreciation expense, the IRS requires you to use your ordinary rate when calculating the tax owed.
For example, let’s say the real estate market is in a normal downward cycle. Even though it’s a buyer’s market, for personal or business reasons you decide to sell to a buyer who offers to pay $105,000. Because your gain is less than your total depreciation tax deductions over the 10 years you’ve owned the property, your tax is based on your ordinary tax rate:
- $99,000 property sales price - $63,640 adjusted cost basis = $35,360 total recognized gain
Because your depreciation expense of $36,360 is greater than your total recognized gain of $35,360, you’ll pay tax based on your ordinary tax rate:
- Total tax owed = $35,360 recognized gain x 24% ordinary tax rate = $8,486
Does depreciation recapture apply for property sold at a loss?
If you sell your rental property for a loss, the rules for recapturing depreciation don’t apply. However, keep in mind that even if you lose money on the sale you’ve still benefited by being able to use the depreciation deduction of $36,360 over the past 10 years to reduce your taxable income.
The IRS also allows you to carry back the loss from a rental property by amending your previous tax returns. You can also carry forward the loss from your rental property investment to offset future income. Topic No. 425 Passive Activities – Losses and Credits and Publication 544 from the IRS explains in detail how losses work for rental real estate activities.
How partial year depreciation works
In the above examples, we’ve used a full year of depreciation, which is 3.363% of the property value each year. However, in the real world of real estate investing, deals take place every month of the year.
Partial year depreciation is calculated based on the month the rental property is put into service. Generally speaking, a rental property is put into service when it is ready and available to be rented, not when a tenant takes possession, according to IRS Publication 527.
That means that if your rental is available for occupancy on February 1st but a tenant doesn’t sign a lease and move in until April 1st, you can still start depreciation the first day of February. The IRS also determines exactly how partial year depreciation works, so that you don’t make a mistake:
- Full year = 3.636%
- January = 3.485%
- February = 3.182%
- March = 2.879%
- April = 2.576%
- May = 2.273%
- June = 1.970%
- July = 1.667%
- August = 1.364%
- September = 1.061%
- October = 0.758%
- November = 0.455%
- December = 0.152%
After your first partial year of service, rental property is depreciated 3.636% for each full year of service, and then partially depreciated again depending on which month of the year you sell.
Can you avoid claiming depreciation?
At this point, you may be wondering if you can avoid dealing with rental property depreciation recapture simply by not claiming depreciation in the first place. Unfortunately, the answer is no.
Internal Revenue Code Section 1250 states that depreciation must be recaptured if depreciation was allowed or allowable. So, even if you don’t claim the annual depreciation expense on rental property that you’re legally entitled to, you’ll still have to pay tax on the gain due to depreciation when you decide to sell.
That’s the bad news. The good news is that while you can’t avoid claiming depreciation, the IRS does allow you to defer paying capital gains tax.
How to defer paying capital gains tax
An IRC Section 1031 tax-deferred exchange is the process that allows real estate investors to defer the payment of capital gains taxes.
The process also goes by other names such as a “Starker exchange”, a “Tax-deferred exchange”, a “Like-kind exchange”, or even just a “1031.” Regardless of the term used, a 1031 exchange originates from Section 1031 of the U.S. Internal Revenue Code.
This section of the Internal Revenue Code allows investors to sell or relinquish an investment property, reinvest the proceeds in a replacement investment property of like kind and greater or equal value, and defer the payment of any capital gains tax.
There are seven simple rules to follow that allow you to defer all capital gains tax:
- Property must be like-kind real estate of the same nature or character but can differ in type, quality or grade (such as commercial property being replaced with a single-family rental property, a multifamily building, or raw land).
- Real estate must be used for investment or business only, not as personal property or not as a primary residence.
- Property must be of equal or greater value, including both the total sale price and replacement of an equal mortgage amount (if a mortgage exists), to avoid paying tax on boot.
- Boot occurs when the value of the replacement property is less than the value of the relinquished property.
- Title of the replacement property purchased must be in the same name as the relinquished property sold.
- Replacement property (or properties) must be identified within 45 days of closing on the sale of the relinquished property
- Purchase of the replacement property (or properties) must occur within 180 days of closing on the sale of the relinquished property
In addition to deferring the payment of capital gains tax on investment real estate, there are a number of other advantages to a 1031 exchange:
- Increase yields and total returns by selling an underperforming property and buying one with higher projected returns
- Diversify a real estate investment portfolio with long-distance real estate investing, by purchasing properties in different geographic locations
- Consolidate several smaller properties into one large property, or divide a single large property into several smaller ones, often for the purposes of estate planning
- Avoid the recapture of depreciation and the resulting increase in taxable income
Final thoughts
It’s always a good idea to talk to your CPA or financial planner about rental property depreciation recapture and potential tax liabilities.
With proper planning, you may be able to minimize your tax liabilities that result from recapturing depreciation or even defer paying any tax by conducting a tax-deferred exchange.
FAQs
In 2022, the recapture tax rate is capped at 25%. Its calculation involves identifying the adjusted cost basis of the asset sold, depreciation deductions or accumulated depreciation, and realized gain. If accumulated depreciation and realized gain are compared, the smaller of the two is taken as the recapture amount.
What is the tax rate for 1250 recapture in 2022? ›
As of 2022, unrecaptured section 1250 gains are subject to the ordinary tax rate, which is maxed out at 25 percent. The recaptured amount is taxed at the capital gain tax rate of 0%, 15% or 20%.
How do I calculate my depreciation recapture on rental property? ›
Calculating Depreciation Recapture
To determine the depreciation recapture, subtract the adjusted cost basis from the sale price for the asset.
How to avoid depreciation recapture tax on rental property? ›
If it's important to you to avoid the depreciation recapture tax, there are several strategies you may want to adopt.
- Take advantage of IRS Section 121 exclusion. ...
- Conduct a 1031 exchange. ...
- Pass on the property to your heirs. ...
- Sell the property at a loss.
Depreciation Recapture tax is 25% across the board, only second to real estate owned less than one year, taxed as ordinary income which could be as high as 37%. Learn more about depreciation recapture tax in this article. The gradual reduction in value of an asset over time.
How is depreciation recapture taxed on rental property? ›
Depreciation expense taken by a real estate investor is recaptured when the property is sold. Depreciation recapture is taxed at an investor's ordinary income tax rate, up to a maximum of 25%. Remaining profits from the sale of a rental property are taxed at the capital gains tax rate of 0%, 15%, or 20%.
Why does 1250 recapture no longer apply? ›
Depreciable real property is often, but not always, depreciated utilizing the straight-line method. In these situations, Sec. 1250 would not be applicable since there would be no additional depreciation to recapture, but the unrecaptured Sec. 1250 gain rules may apply.
What is the tax rate for depreciation recapture in 2023? ›
So part of the gain beyond the original cost basis would be taxed as a capital gain but the part that relates to depreciation is taxed at the 1250 rule rate. The unrecaptured section 1250 rate is capped at 25% for 2023.
Why does 1250 recapture generally no longer apply? ›
Why does §1250 recapture generally no longer apply? Congress repealed the code section. The Tax Reform Act of 1986 changed the depreciation of real property to the straight-line method.
How does IRS calculate depreciation recapture? ›
How to Calculate Depreciation Recapture
- 1.) First, calculate the adjusted tax basis: ...
- 2.) Calculate the realized gain: ...
- 3.) The depreciation recapture value is the amount of depreciation taken multiplied by a 25% rate: ...
- 4.) The remaining gain is taxed at the capital gains rate of 0%, 15%, or 20%:
Section 1250 depreciation, which is deducted over 39 years using the straight-line method, will generate accumulated depreciation over the years. This accumulated 1250 depreciation is taxed at a flat rate of 25% upon disposition (sale), up to a maximum of the amount of the recognized gain.
What triggers depreciation recapture? ›
Depreciation recapture is assessed when the sale price of an asset exceeds the tax basis or adjusted cost basis. The difference between these figures is thus "recaptured" by reporting it as ordinary income.
What happens when you sell a fully depreciated property? ›
When selling the property, however, the depreciation that has been taken must be recaptured and paid back to the government. This is because depreciation is considered to be a form of deferred income, and when the property is sold, the deferred income becomes taxable.
What is an example of a depreciation recapture tax? ›
Examples of Depreciation Recapture
The adjusted cost basis will be $1,000,000 – ($5,000 * 5) = $975,000. The gain from the sale will be the adjusted cost basis subtracted from the sale price: $990,000 – $975,000 = $15,000. As a result, when filing taxes, the property owner will need to file $15,000 in ordinary income.
What is an example of depreciation recapture? ›
Examples of Depreciation Recapture
You'd owe $6,750 in tax if the IRS taxed your claimed depreciation amount ($27,000 total) at the 25% depreciation recapture rate, and you might owe capital gains tax as well.
Does depreciation recapture ever go away? ›
If the realized gain ends up being negative (a realized loss), there is no depreciation recapture as you sold the item for a loss and will not need to pay income or capital gains taxes.
What can offset depreciation recapture? ›
If you swap one investment property for another and roll the entirety of sales proceeds into the new asset, you can defer both depreciation recapture and capital gains taxes. If you divest the replacement asset, though, you'll have to pay the accumulated depreciation recapture and capital gains taxes.
What is the 5 year recapture rule? ›
The rehabilitation credit under Internal Revenue Code § 47 is subject to recapture if the building on which it was claimed is sold or ceases to be business use property within five years from the date it was first placed in service.
Is recapture 100% taxable? ›
In a way, Section 1250 recapture is in between capital gain and ordinary income. This class of income is still treated as capital gain on Schedule D, but is taxed at ordinary rates, with a cap of 25%.
Is depreciation recapture taxed as ordinary income or capital gains? ›
Depreciation recapture is the portion of your gain attributable to the depreciation you took on your property during prior years of ownership, also known as accumulated depreciation. Depreciation recapture is generally taxed as ordinary income up to a maximum rate of 25%.
IRS Code Section 1250 states that depreciation must be recaptured if it is allowable for the property. So, even if you don't claim depreciation for the years you owned the property, you'll still have to pay tax on the gain when you decide to sell.
What is the difference between 1250 recapture and unrecaptured 1250? ›
This Section 1250 depreciation recapture is taxed at ordinary income rates. Any gain in excess of the amount treated as ordinary income because of Section 1250 recapture, but not exceeding the total depreciation claimed, is "unrecaptured Section 1250 gain".
What property is subject to 1250 recapture? ›
Section 1250 addresses the taxing of gains from the sale of depreciable real property, such as commercial buildings, warehouses, barns, rental properties, and their structural components at an ordinary tax rate. However, tangible and intangible personal properties and land acreage do not fall under this tax regulation.
What is the maximum recapture? ›
What is the maximum recapture tax? The maximum recapture tax is 6.25% of the original principal balance of the loan or 50% of the gain on the sale of your home whichever is less.
What are the new depreciation rules for 2023? ›
The rules allow Bonus Depreciation to 100% for all qualified purchases made between September 27, 2017 and January 1, 2023. Bonus Depreciation now ramps down to 80%, starting in 2023. Bonus depreciation will continue to ramp down for ensuing years: 60% for 2024, 40% for 2025, 20% for 2026, and 0% beginning in 2027.
What is the depreciation limit for listed property in 2023? ›
For 2023, first-year Bonus Depreciation is 80% of the purchase price. It falls to 60% in 2024, 40% in 2025, and 20% in 2026.
What are the tax changes for 2023 capital gains? ›
Long-term capital gains tax rates for the 2023 tax year
In 2023, individual filers won't pay any capital gains tax if their total taxable income is $44,625 or less. The rate jumps to 15 percent on capital gains, if their income is $44,626 to $492,300. Above that income level the rate climbs to 20 percent.
Do you have to recapture depreciation on 1250 property? ›
The entire amount of depreciation claimed on section 1245 property, including bonus depreciation and the section 179 expense allowance, is recaptured as ordinary income to the extent of gain. In the case of section 1250 property, however, only “excess depreciation” is subject to recapture.
Does depreciation recapture apply to 1250 property? ›
§1250, Section 1250 Depreciation Recapture
The applicable percentage of additional depreciation subject to recapture is 100 percent for depreciation claimed after 1975 except in the case of certain low-income housing.
How to avoid unrecaptured Section 1250 gain? ›
Since the unrecaptured section 1250 gains are considered a form of capital gains, they can be offset by capital losses. To do so, the capital losses must be reported through Form 8949 and Schedule D, and the value of the loss may vary depending on if it is determined to be short-term or long-term in nature.
Internal Revenue Code Section 1250 states that depreciation must be recaptured if depreciation was allowed or allowable. So, even if you don't claim the annual depreciation expense on rental property that you're legally entitled to, you'll still have to pay tax on the gain due to depreciation when you decide to sell.
What is the basis for depreciation of rental property? ›
Depreciation commences as soon as the property is placed in service or available to use as a rental. By convention, most U.S. residential rental property is depreciated at a rate of 3.636% each year for 27.5 years. Only the value of buildings can be depreciated; you cannot depreciate land.
What is the tax rate for bonus depreciation recapture? ›
Is bonus depreciation subject to recapture? Yes, when property, for which bonus depreciation was claimed, is sold that depreciation is recaptured and taxed as regular income. However, there's a cap on the tax rate of 25%.
Can depreciation recapture put you in higher tax bracket? ›
Recaptured depreciation is added to your AGI in the tax year of recapture. However, that recaptured depreciation itself is taxed as ordinary income anywhere from 0% to a maximum of 25%. So even if the AGI increase puts you in a higher tax bracket, that recaptured depreciation will not be taxed at more than 25%.
What is the maximum tax rate for recaptured 1245 gain? ›
Furthermore, Section 1245 recapture is taxed at your ordinary income tax rate with no cap, while Section 1250 recapture is taxed at your ordinary income rate but is capped off at 25%.
Is rental property 1245 or 1250? ›
Any depreciable property that is not section 1245 property is by default section 1250 property. The most common examples of section 1250 property are commercial buildings (MACRS 39-year real property) and residential rental property (MACRS 27.5-year residential rental property).
How do you avoid bonus depreciation recapture? ›
The 1031 exchange is one of the most effective tools in the investor's arsenal to avoid the sting of the bonus depreciation recapture tax in the year that they sell their investment property.
What is the depreciation recapture tax rate for 2023? ›
So part of the gain beyond the original cost basis would be taxed as a capital gain but the part that relates to depreciation is taxed at the 1250 rule rate. The unrecaptured section 1250 rate is capped at 25% for 2023.
What is the max tax on depreciation recapture? ›
Depreciation recapture is the portion of your gain attributable to the depreciation you took on your property during prior years of ownership, also known as accumulated depreciation. Depreciation recapture is generally taxed as ordinary income up to a maximum rate of 25%.
How do you calculate depreciation recapture tax? ›
The recapture tax rate is usually taxed at 25%, which you will multiply by the amount of your depreciated value. Luckily, the IRS won't ask for all the money back, but they will ask for a portion to make up for the years of tax deductions.
Key Takeaways. An unrecaptured section 1250 gain is an income tax provision designed to recapture the portion of a gain related to previously used depreciation allowances. It is only applicable to the sale of depreciable real estate. Unrecaptured section 1250 gains are usually taxed at a 25% maximum rate.
What are the depreciation changes for 2023? ›
The Tax Cuts and Jobs Act of 2017, however, begins to phase out bonus depreciation starting in 2023 by dropping the maximum amount to 80%. The deduction then phases out over the next four years: 80% in 2023, 60% in 2024, 40% in 2025, and 20% in 2026.
What happens when you sell a depreciated rental property? ›
When you sell a rental property, the depreciation is recaptured and taxed as ordinary income at your marginal tax rate, up to a maximum 25% rate. Fortunately, investors can use a couple of strategies to minimize the impact of depreciation recapture tax.
What happens when you sell a fully depreciated asset? ›
When the fully depreciated asset is eventually disposed of, the accumulated depreciation account is debited and the asset account is credited in the amount of its original cost.
What is the difference between 1250 recapture and unrecaptured 1250 gain? ›
This Section 1250 depreciation recapture is taxed at ordinary income rates. Any gain in excess of the amount treated as ordinary income because of Section 1250 recapture, but not exceeding the total depreciation claimed, is "unrecaptured Section 1250 gain".
Which depreciation method is best for tax purposes? ›
The straight-line method of depreciation is one of the most effective methods of allocating the cost of capital assets. With the straight-line method, assets' values are reduced uniformly in every period until it reaches the salvage value, or the end of an asset's useful life.
