Editor’s note: After I posted my recent rental property cash flow analysis, the topic of depreciation came up in the comments. My friend Jason Hull then offered to share his thoughts on the often overlooked topic of depreciation recapture. So here ya go…
“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 you that you could be a real estate mogul.
been suckered into purchased a course on real estate investing by Russ Whitney, and it was going to be easy peasy to make my riches off of real estate.
I found a VA foreclosure in a good part of town, put in a bid, got a loan, and, voila (well, with a few more steps than that), I 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 was going 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.
So, I asked my Realtor if she could rent it out. Fortunately, the house was in a military town, and renters were easy to find, so once 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 that I could reduce the income using depreciation. Lower taxes FTW!
Did I mention that I didn’t know what the heck I was doing when I got into that rental property? Everything I knew about real estate, at that point, I’d learned from Russ Whitney. You can guess the sum total of my real estate knowledge.
Depreciation and Real Estate
Allow me a moment to explain this concept of depreciation. Depreciation is the notion that, 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 that you paid for the item (you’re getting value out of it, after all) – the IRS accounts for the life expectancy of the item. It allows you to reduce your income by the amount of life expectancy that expired for that object in the past year.
This only works for items which you buy to create business income: office furniture, software, buildings, and the like. 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 is 27.5 years. Land never gets depreciated because it can’t be used up (excepting mines, quarries, and similar property, but that’s beyond the scope of this article).
This means that for every year that you have a rental property, you get to take 1/27.5th of your basis in the property as a deduction against the income on that property.
It’s depreciation which generally allows you to be cash flow positive on a property yet report a tax loss. Here’s an example.
Simple Real Estate Depreciation Example
I buy a rental property on January 1 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 that year, I can take 1/27.5 X $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. That doesn’t mean the house itself is worthless, simply that, in the IRS’s eyes, it is.
Back to the story.
I’d decided to compound my educational misery by adding a 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 (I’d married by this time) was estimating it would take a month or two to get another renter in.
My wife and I didn’t like staring down the barrel of any mortgage payment not matched by rent, so we asked the property manager cum Realtor if she could sell it quickly. She could! And she could sell it for a little bit more than we paid for it. Donald Trump, here I come! I was expecting a little bit of capital gains tax in that year’s tax return, but I was shocked to see this much bigger tax hit on that year’s taxes. What had happened?
Depreciation Recapture – The IRS Giveth and 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, which 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 that most real estate investors don’t realize is that 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, but if you’re at a higher rate, it’s a hefty increase.
Depreciation Recapture Example
Let’s do an example, assuming you have a 28% ordinary income tax rate and a 20% long-term capital gains rate (the 2013 rate). You bought a rental house on January 1, 2008 for $100,000. The house was $80,000, and the land was $20,000. According to the IRS, your annual depreciation is $2,909.09 ($80,000 / 27.5). You sell the rental house on December 31, 2013 for $125,000 (you go!). Your basis on the property as of the time you sold it is $85,454.55. Thus, your gain is as follows:
- Depreciation Recapture (25% tax rate): $14,545.45. You owe $3,636.36 in tax on this amount (25% X $14,545.45).
- Long-term capital gain (20% tax rate): $25,000. You owe $5,000 in tax on this amount (20% X $25,000).
- Total tax due: $8,636.36
A lot of real estate investors forget about that extra $3,636.36 that they’d owe the IRS until their tax preparer (or the IRS) reminds them of this extra bundle of joy in the tax return.
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 that 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.
Advanced Strategies to Deal with Depreciation Recapture
There are a bunch of strategies involved with rental real estate that can affect what happens, such as income timing, section 1031 exchanges, estate planning, and even 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.
Jason Hull is a candidate for the CFP(R) Board’s certification, is a Series 65 securities license holder, owns Hull Financial Planning. He is also a personal finance columnist for U.S. News & World Report.