What Is Depreciation Recapture?


The term “depreciation recapture” refers to the amount of gain that is treated as ordinary income upon the sale or other disposition of property.  Gain that is treated as capital gain is not depreciation recapture.  If you do your own taxes and you never heard of “depreciation recapture” – it’s time to get an accountant. If you already have an accountant and they never discussed “depreciation recapture” with you – you need a new accountant!  Either way, this post will walk you through some of the basics.

A Simple Example
Let’s begin with an example. You bought a rental property in 2007 for $200K. True, this was right before the “great financial crisis” and your property is worth less, but that is besides the point (for the moment).  In 2014, you manage to sell it for $175K. If life was simple, you could get away with the following calculation: your loss is the $175K sales prices less the $200K purchase price, or $25K. You held the property more than a year, therefore it’s “long-term.” Done right?  Not so fast my friend.

Unfortunately, it is not so simple, and instead of having a loss, you actually have a gain. How come? Because of depreciation. Every year since 2007 you were depreciating the property, correct?  Well, that depreciation lowered your tax bill and you received a benefit because of it.  But if you think you got a free ride from the government, think again.  What you were saving on depreciation comes back to haunt you now when you sell the property. So (for simplicity) let’s assume that each year you received $7,272 in depreciation. This is approximately $51K of depreciation over the 7 years.  Thus, the building wasn’t really wrth $200K for tax purposes, but only $149K.  SInce you sold the building for $175K, you really had a $26K gain!

It gets worse. Under “normal” circumstances, the tax rate on most net capital gain is no higher than 15%. Some may be taxed at 0% if you are in the 10% or 15% ordinary income tax brackets. However, a 20% rate on net capital gain applies in tax years 2013 and later to the extent that a taxpayer’s taxable income exceeds the thresholds.  Furthermore, there are a few other exceptions where capital gains may be taxed at rates greater than 15%:

  1. The taxable part of a gain from selling section 1202 qualified small business stock is taxed at a maximum 28% rate.
  2. Net capital gains from selling collectibles (like coins or art) are taxed at a maximum 28% rate.
  3. The portion of any unrecaptured section 1250 gain from selling section 1250 real property is taxed at a maximum 25% rate.

In case you missed it, it’s that last bullet that refers to depreciation recapture.  And yes, it’s taxed at 25% versus 15%!

The actual calculations can get quite involved depending on the amount of the gain, the amount of depreciation taken and the tax bracket you fall into.  But once again for simplicity (and illustration), since you took $51K of depreciation, the entire $26K gain would be considered depreciation recapture and you could pay $9K in taxes related to it.

If you’re tired at this point, we don’t blame you. Albert Einstein is quoted as saying that the hardest thing in the world to understand is the income tax.  As seen above, the IRS does a pretty good job proving his point!

Tax Planning Tips for Depreciation Recapture
So just how can you get out of depreciation recapture?  The short answers is you can’t, but there are things that can help or delay it’s payment.  For example, when a rental property is sold, any passive activity losses that were not deductible in previous years become deductible in full. This can help offset the tax bite of the depreciation recapture tax.

By the way, you’ve heard of 1031 exchanges, haven’t you?  Next time, you may want to think about using one before you sell your property.  When a rental property is sold as part of a like-kind exchange, both capital gains and depreciation recapture taxes can be deferred until the “new” property is disposed of.

There’s one tax strategy, however, that will not help. Since depreciation is recaptured when the asset is sold, it is reasonable that some people would think that by avoiding claiming depreciation they can also avoid the recapture tax. This strategy does not work, because the tax law requires depreciation recapture to be calculated on depreciation that was “allowed or allowable” (Internal Revenue Code section 1250(b)(3)).

Understanding The 1031 Exchange

Most real estate investors have at least heard of the 1031 exchange, but very few have actually completed such a transaction.  The 1031 exchange is a powerful tool to have in your creative real estate arsenal, as it allows you to dispose of one property and acquire another without paying capital gains tax on the property you are disposing of.

However, a 1031 exchange requires careful attention to the requirements, particularly as they relate to timing, in order to avoid potential ghoulish dealings with the IRS.

To start with, it is important to understand exactly what a 1031 exchange is.  Named after the section of the Internal Revenue Code under which it resides, a 1031 exchange is the swap of one asset for another similar asset.  In other words, in order to take advantage of this tax section, the type of property swapped must be of a similar “nature or character.” For example, livestock of different genders are not considered like-kind property.

Fortunately, this is not much of an issue with real estate, as the code allows for the exchange of any real property for any other real property.  The property (generally) must be a business or investment asset, meaning the property generates revenue or helps in generating revenue.  Typically, these properties will be warehouses, offices or rental homes.  Primary residences and other property that do not generate regular income do not qualify, such as a second home or vacation home.

Properties located inside and outside the country cannot be exchanged for each other.  Also, real property cannot be exchanged for personal property, such as a house for farm equipment.  Lastly, personal residences are not eligible for like-kind exchanges; the property must have been an investment or business property to qualify.

One of the nicest features of the rule is that the properties do not have to be of similar “grade or quality.” In other words, it’s perfectly legitimate to exchange a house in much need of repairs for a property that is in pristine condition.  The like-kind exchange is an ideal vehicle for trading up properties without paying capital gains taxes.

Timing is a key element to a successful 1031 exchange.  In order to qualify for the capital gains deferral, the decision to treat a property sale as part of a 1031 exchange needs to be made before the closing date of the sale of that property.  Then, the seller must identify the property to be acquired in the exchange within 45 days of the closing date of the sold property.  The new property must then be acquired within 180 days of the date that the prior property was sold.

The 1031 Exchange Process Outlined Visually

The 1031 Exchange Process Outlined Visually

When it comes to identifying the replacement property, there are some interesting rules, and you can pick which rule you want to follow.  The property needs to be of equal or greater value, but you can select multiple properties as potential properties to buy, subject to the following rules:

1.  You can select up to three distinct properties as possible replacement properties for the exchange, regardless of their value, OR…

2.  You can select any number of properties, as long as their total fair market value does not exceed double the value of the property you sold, OR…

3.  You can select any number of potential properties to buy, as long as the fair market value of the property you eventually close on within the 180 day window is at least 95% of the value of the property you sold.

In order to protect the “integrity” of the like-kind exchange, the IRS requires that you use a qualified intermediary in order to complete the transaction and qualify for the capital gains exclusion.  The qualified intermediary escrows the proceeds from the sale of the first property, and ensures that the funds are only used to acquire a like-kind property.

The qualified intermediary works with your title company, escrow company, or closing attorney to facilitate the transaction.  The key element of this part of the transaction is to ensure that you never actually obtain receipt of the funds from the property sold, and there is no record of it passing through your own personal accounts.

Normally when an investment property is sold, you must recapture the sum total of the depreciation you have claimed on the property.  In other words, your taxable capital gains include not only the actual appreciation in the property’s value, but also the amount that you deducted as depreciation over the time you owned.

A beautiful benefit of the 1031 exchange is that there is no depreciation recapture required.  Instead, the accumulated depreciation in the old property affects your basis in the new property you are buying in the exchange.

Since the purpose of the like-kind exchange is to avoid paying capital gains tax on appreciation of properties, there is no benefit to using a 1031 exchange on a property on which you have a loss.  By selling a property for a loss, a portion of that loss becomes deductible.  The 1031 exchange rules do not recognize losses as an adjustment to the basis in the newly acquired property, so there is no benefit in using this vehicle for that purpose.

Our hope is that this article has provided you with enough information to make the decision of when to use the 1031 exchange rules to your benefit.  As with all things, however, be sure to consult with a licensed tax professional for advice regarding your specific transaction, and remember that you must use a Qualified Intermediary in order to complete the transaction.

Are you are thinking of disposing of your property and have questions?  Why not give us a call?  We are here to help, and only a phone call away!

By |2013-11-25T19:45:41-06:00November 25, 2013|Categories: Tax Talk|Tags: , , , , , |Comments Off on Understanding The 1031 Exchange
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