Written by Randall Weaver, CPA
Depreciation is a valuable tax benefit for real estate investors, allowing them to reduce taxable income by accounting for the wear and tear of rental properties over time. However, when it comes time to sell, investors may face a tax burden known as depreciation recapture, a critical aspect of real estate taxation that can impact net profits and investment strategy. Understanding how depreciation recapture works, its tax implications, and strategies to mitigate it is important for maximizing returns.
What Is Depreciation Recapture?
Depreciation recapture is a tax imposed when a property that has benefited from depreciation deductions is sold for more than its adjusted basis (original cost minus accumulated depreciation). The Internal Revenue Services (IRS) requires investors to recapture a portion of these previously claimed deductions by taxing them as ordinary income, rather than at lower capital gains rates.
For residential rental properties, depreciation is typically calculated using the Modified Accelerated Cost Recovery System (MACRS) over 27.5 years, while commercial properties are depreciated over 39 years. When a property is sold for more than its adjusted basis, the IRS considers the amount of depreciation claimed as taxable income, subject to a maximum rate of 25%.
For properties where a cost segregation study was performed and a five-year and 15-year property were each identified, extra planning is needed because the recapture on the shorter depreciation lives are recaptured at ordinary income tax rates and this recapture is not capped at a maximum of 25% — it could be taxed as high as 37%.
Key Takeaways
- Depreciation recapture is a tax imposed on the portion of a property's gain that results from prior depreciation deductions, with a maximum rate of 25%.
- Special planning and consideration are required if the property had a cost segregation study performed on it to manage the tax impact of depreciation recapture at ordinary income tax rates as high as 37%.
- Investors can defer depreciation recapture using a 1031 exchange or offset gains with losses from other investments.
- Converting a rental property to a primary residence or holding it until death can help reduce or eliminate recapture taxes.
- Proper tax planning and consultation with an advisor can help investors minimize their tax burden and maximize profits when selling real estate.
How Depreciation Recapture Is Calculated
The amount subject to depreciation recapture is the total depreciation taken or the gain from the sale, whichever is lower. Here’s a simple example:
- Original Purchase Price: $300,000
- Accumulated Depreciation: $50,000
- Adjusted Basis: $250,000 ($300,000 - $50,000)
- Sale Price: $350,000
- Total Gain: $100,000 ($350,000 - $250,000)
- Depreciation Recapture Amount: $50,000 (taxed at 25%)
- Remaining Gain Subject to Capital Gains Tax: $50,000
In this scenario, the investor would pay up to 25% on the $50,000 of depreciation recapture. The remaining gain would be taxed at the capital gains rate (typically 15-20%, depending on the investor’s tax bracket) and the Net Investment Income tax (NIIT) which is 3.8% for households over a certain income threshold.
Strategies to Mitigate Depreciation Recapture
Investors can use several strategies to reduce or defer the impact of depreciation recapture:
1. Utilize a 1031 Exchange
A 1031 like-kind exchange allows investors to defer depreciation recapture and capital gains taxes by reinvesting the proceeds into another qualifying property. This strategy preserves capital and continues tax-deferred growth.
2. Offset Gains with Capital Losses
If an investor has capital losses from other investments (such as stocks or other real estate holdings), they can use those losses to offset gains from depreciation recapture, reducing overall tax liability.
3. Offset Gains with Passive Losses
If an investor has suspended passive rental losses, they can use those losses to offset gains from depreciation recapture, reducing overall tax liability.
4. Convert to a Primary Residence
In some cases, converting a rental property into a primary residence before selling can provide tax advantages. If the property meets the Section 121 Exclusion rules (living in it for at least two out of the last five years), investors may exclude up to $250,000 ($500,000 for married couples) of capital gains—though depreciation recapture still applies.
5. Hold the Property Until Death
Under current U.S. tax law, inherited properties receive a step-up in basis to their fair market value at the time of the owner’s death. This eliminates depreciation recapture and capital gains tax for heirs, making it an attractive estate planning strategy.
Depreciation recapture is an unavoidable part of real estate investing, but with careful planning, investors can mitigate its impact and optimize their long-term financial strategy. Understanding these tax implications in advance allows for smarter investment decisions and a more effective wealth-building approach.
