Depreciation Recapture for Landlords

“Lay up your treasures in heaven where there is no depreciation.” —Unknown

The very first time I bought a house, I had this grandiose idea of being a flipper.

This was long before television channels like HGTV could convince everyone they could be a real estate mogul.

I had been suckered into purchased a course on real estate investing by Russ Whitney, and it was supposed to be easy peasy to make my riches off of real estate.

Instead, I ended up as a landord, quickly learning the benefits of depreciation recapture.

What is Depreciation Recapture?

Depriciation recapture is the policy of the IRS that an individual or business cannot claim a depreciation reduction and then, when the property is sold, only pay capital gains taxes on the money that was deducted.

Basically, the money you deduct in depreciation on a real estate asset has to be taxed at the regular income tax rates when that asset is sold for a profit.

If all that seems a bit fuzzy, keep reading as we explore depreciation on my rental property and then deep dive into the depreciation recapture I had to pay.

Buying My First Property

I found a Veteran Affairs (VA) foreclosure in a good part of town, put in a bid, got a loan, and, voila!

Well, maybe a few more steps than that, but I now owned a house which had been slightly undervalued, needed a few touch-ups, and would be ready to go.

I was taking advantage of an illiquid and inefficient market, and I has plans to mark up the property, sell it, and laugh all the way to the bank.

Alas, that only works in infomercials.

The property sat on the market for four months. I was heading off to law school, which was in another state, and I sure didn’t need a mortgage to try to account for as a broke law school student.

To try to get out of the bind, I asked my Realtor if she could rent it out.

Fortunately, the house was in a military town, and renters were easy to find. She put it up for rent, it rented quickly. A year went by with a rent check coming in to cover the mortgage payment.

I did my taxes and got this pleasant surprise when I found out I could reduce the income using depreciation.

Depreciation and Real Estate

Let me explain this concept of depreciation.

Depreciation is the notion where, over time, objects which you buy will reach the end of their useful lives.

Since, when you file your taxes, you cannot immediately expense these items—in other words, you can’t immediately reduce your income by the amount you paid for the item (you’re getting value out of it, after all)—the IRS accounts for the life expectancy of the item.

Essentially, it allows you to reduce your income by the amount of life expectancy which expired for that object in the past year.

This only works for items which you buy to create business income:

• office furniture
• software
• equipment
• machinery
• buildings
• cars, trucks, or utility vehicles

It doesn’t work for the 183” flat screen TV in your man cave, unfortunately.

For residential real estate—the building, not the land—the life expectancy was 27.5 years. Land never gets depreciated because it can’t be used up (except mines, quarries, and similar property, but that’s beyond the scope right now).

This means for every year you have a rental property, you get to take 1/27.5th (around 3.63%) of your basis in the property as a deduction against the income on the property.

This depreciation, which generally allows you to be cash flow positive on a property, may help you actually report a tax loss.

Here’s an example.

Simple Real Estate Depreciation Example

I buy a rental property on January 1st for $100,000.

The land is worth $20,000 and the house is worth $80,000. I then rent it out.

When I file taxes for the year, I can take 1/27.5 multiplied by $80,000 as a depreciation expense, reducing my taxable income on that property by $2,909.09.

If I rented the house out for $500 a month and had no other expenses (yes, this is an EXAMPLE… I realize this doesn’t happen in real life), I’d have $6,000 in income. But, I only have to pay taxes on $3,090.91 due to the depreciation.

I can do that for 27.5 years, until I’ve completely depreciated the property.

This doesn’t mean the house itself is worthless, simply that, according to the tax code, it is.

Back to the story.

Offloading the Property

I decided to compound my educational misery by adding an MBA to my education, tacking on another year’s worth of student loan expenses to my Sallie Mae anchor.

Additionally, our renters were moving on to another duty station, and our property manager (who I married by this time) was estimating it would take a month or two to get another renter in.

My now wife and I didn’t like staring down the barrel of any mortgage payment not matched by rent, so we asked the Realtor if she could sell it quickly.

She could! And she could sell it for a little bit more than we paid for it. Win-win!

I was expecting a little bit of capital gains tax in that year’s tax return, but I was shocked to see a much bigger tax hit!

What had happened?

Understanding Depreciation Recapture

The IRS giveth, and the IRS taketh away.

If you were able to depreciate property, take a deduction on it, and then sell your property and only take capital gains as if you’d never depreciated the property, you’d be double dipping.

This would be great for you, but mean less revenues for the IRS—something which will RARELY happen.

To prevent this from happening, the IRS uses a method called depreciation recapture to get its pound of flesh back from you.

Depreciation Recapture Tax Rate

The big “gotcha” about depreciation recapture most real estate investors don’t realize is it’s taxed at ordinary income tax rates, maxed out at 25% plus the 3.8% net investment income tax (if applicable)—not at capital gains rates!

If you’re in a low tax bracket, this isn’t a big deal, and might even be a benefit. If you’re at a higher rate, it’s a hefty increase.

But how does it work?

Let’s go through another example.

Depreciation Recapture Example

Let’s assume I have a 28% ordinary income tax rate and a 20% long-term capital gains rate.

I bought a rental house on January 1st for $100,000. The house was $80,000, and the land was $20,000.

According to the IRS, the annual depreciation is $2,909.09 ($80,000 x  1/27.5).

I sell the rental house 5 years later on December 31st for $125,000, for a nice profit.

My basis on the property at the time I sold it is $85,454.55.

Thus, my gain is as follows:

1. Depreciation Recapture (25% tax rate): $17,454.55. You owe $4,363.64 in tax on this amount (25% X $17,454.55).
2. Long-term capital gain (20% tax rate): $25,000. You owe $5,000 in tax on this amount (20% X $25,000).
3. Total tax due: $9,363.64

A lot of real estate investors forget about that extra $4,363.64 they’d owe the IRS until their tax preparer (or the IRS) reminds them.

NOTE: Depreciation recapture is only triggered upon the sale of the property.

If you never sell the property and pass it on to your heirs, they get a stepped up basis to the fair market value at the time you peel the garlic, and the depreciation goes away. It’s the one time the IRS doesn’t get its due.

You might be thinking to yourself, “Self, I’m just not going to take depreciation. That way, I avoid depreciation recapture!”

While this might be good in theory, it’s not good in practice. The IRS says they can claim depreciation recapture on any allowable depreciation, regardless of whether or not you took depreciation.

So, if you don’t take depreciation, you’ll still have to pay tax on the depreciation recapture.

May as well get the benefit of depreciation if you’re going to have to pay for depreciation recapture.

Selling the Propery at a Loss

If a landlord were to sell the property at a loss, the rules for depreciation recapture are moot.

What is great about this is you already got the benefit of taking the depreciation reduction on your previous tax years.

On top of that, the loss you take on the property can be filed on previous tax years or carried forward to future years to offset future income. Publication 544 and Topic #425 explain how losses on rental real estate work with the tax code.

Avoiding Depreciation

You made it this far and you might be thinking, “Let’s not claim depreciationg so we can avoid this whole thing in the future.” Well, it doesn’t work that way.

The IRS has no problem making things complicated for you, but does want things simple for itself. In IRS Code 1250 we find a line that states the depreciation recapture will go into effect for any allowed or allowable deductions.

To put that simply, if you don’t take the deductions you just miss out and they are still going to charge you under the rules of depreciation recapture. So take the deduction, you aren’t going to avoid depreciating recapture.

Advanced Strategies for Depreciation Recapture

There are a bunch of strategies involved with rental real estate which can affect what happens, such as:

• income timing
• section 1031 exchanges
• estate planning, and
• self-directed IRA planning

If you really want to delve into the strategies, it’s probably worth a couple of hours of a financial planner or CPA’s time to make sure you have your plan of attack straight before you get started.

Whatever you do, don’t go spending all of your gains when you sell your rental property. Remember, the tax man cometh!

To read more about this topic, you can check out the IRS publication 544, “Sales and Other Disposition of Assets” (homes are considered Section 1250 property) and IRS publication 527, “Residential Rental Property.”

Do you have any thoughts or questions about depreciation recapture? If so, leave them in the comments below.