If you claimed depreciation on a rental or investment property, you may owe depreciation recapture when you sell. The recapture tax is 25% of the total depreciation taken (or allowable), regardless of your income tax bracket.
Depreciation recapture can be a significant tax hit. Proper planning can help you minimize or defer the tax.
What Is Depreciation Recapture?
When you own a rental property, you can deduct depreciation each year as a paper expense against your rental income. This reduces your taxable income during the years you own the property. When you sell, the IRS recaptures those deductions by taxing the accumulated depreciation at a 25% rate (or your ordinary income rate if lower).
How to Calculate Recapture
The recapture amount is the total depreciation you claimed (or could have claimed) over the ownership period. The building structure is depreciated over 27.5 years for residential rentals. If you owned a $300,000 rental property with $200,000 in building value, annual depreciation would be about $7,273. After 10 years that is roughly $72,730 in depreciation. The recapture tax at 25% would be about $18,182 on top of any capital gains tax on the sale.
How to Minimize Depreciation Recapture
A 1031 exchange allows you to defer both depreciation recapture and capital gains tax by reinvesting the proceeds into a like-kind property. The recapture carries over to the new property. Another strategy is to convert the rental to a primary residence before selling, which may allow you to take advantage of the $250K/$500K capital gains exclusion. However, depreciation recapture still applies to depreciation taken after 1997. Work with a tax professional to plan your sale strategy.
As a dual-licensed loan officer and realtor, I work with investors regularly and can connect you with tax professionals who specialize in real estate.
