Depreciation's Tax Break Has Consequences for Real Estate Investors
Property owners may love the tax deduction now, but when they sell, the IRS may come knocking for what is due through "depreciation recapture." Here's how that works.
Real estate investing provides many tax benefits, and depreciation is one of the biggest. It’s also one of the more misunderstood.
Depreciation lets you deduct a portion of the cost of the investment each year for the length of its IRS-designated life span. The depreciation computation is figured based on the value of the improvements, not on the land underneath the improvements. This necessitates that you be able to determine the value of the land and the value of the improvements. This determination is generally included in the multitude of closing documents you received when buying the property or found on the county real estate tax website. It is essential that you keep your closing documents. There are additional loan costs that can be expensed and that must be amortized involved in the closing itself.
A hypothetical example
Very often a real estate investment that is cash positive will turn into a loss (on paper) once depreciation is included in the cost. Take, for example, a rental property costing $50,000 that brings in about $575 a month in rent. The debt service on the mortgage, which covers the repayment of interest and principal, would be about $260 per month. Add in taxes and insurance and you get to expenses of about $460 a month. This puts a little over $100 in your pocket each month before depreciation expenses are included.
Depreciation on a $50,000 property would be about $150 a month based on dividing the $50,000 cost by 330 months, the length of life the IRS assigns to residential rental property. That gives you a loss of about $50 a month. This “loss” of $600 a year is allowed (up to $25,000) to be deducted against your earned income if you meet the AGI requirements.
However, that tax break comes with some consequences later. When you eventually sell the property, the IRS will impose what is called “depreciation recapture” to recapture the taxes you would have paid over the years without the benefit of claiming depreciation. The depreciation recapture portion of your capital gain is taxed at your ordinary tax rate, not the capital gains rate.
Now, if you are keeping track, the long-term capital gains tax rate for all but the wealthiest of people is 15%, and a pretty average ordinary tax rate is about 25%. So, the thinking man may say, “Well since the depreciation recapture tax rate is higher than the capital gains rate, I just won’t take any depreciation.” On the face of it that makes sense. Not so fast. The IRS has thought about this and created a rule that when a person sells an investment property the depreciation recapture tax is computed on the amount of depreciation taken or the amount of depreciation that should have been taken. So, the IRS will tax you on depreciation recapture whether or not you take it, so it makes sense to take it.
Doing the math
So, since one of the biggest questions I get about depreciation is “How do you compute depreciation recapture?” I will attempt to simplify and explain it.
- The first thing you will need is the cost basis of the property, in our prior example $50,000. This should have been computed at the very beginning when you started taking depreciation. Generally, this amount is somewhat close to what you originally paid for the property.
- Next you need to compute the total depreciation that you took (or that you should have been taking). Say, in our case, we took a total of $10,000. If you had a professional prepare your taxes this is probably included as a schedule in your last year’s tax filing. A lot of the online tax software programs miss this information.
- Then you subtract the amount of depreciation taken (or that should have been taken) from the original cost basis. This is known as the “adjusted cost basis” of your property, in our example it would be $40,000.
- Next you need the amount you sold the property for minus any fees or commissions. This is known as your “net proceeds.” In our example, say we sold it for $60,000 and paid $5,000 in selling costs, so our net proceeds would be $55,000.
- Take the net proceeds figure and subtract from it the adjusted cost basis: $55,000-$40,000=$15,000. This is the amount of gain you have realized.
- Compare your realized gain with your depreciation expense: $15,000>$10,000. The lower of the two figures is the amount the IRS considers subject to depreciation recapture at your ordinary income tax rate. In this case, $10,000 is subject to depreciation recapture at your ordinary income rate. The remaining $5,000 is taxed at the capital gains rate.
The depreciation deduction is a very valuable real estate investor benefit. When taken, it can provide an immediate deduction that ultimately reduces an individual’s tax liability. The depreciation recapture should be figured into any selling scenario. Fully understanding your tax liability upon the sale of the property could make or break the selling decision.
About the Author
Scott Vance is a fee-only planner and Enrolled Agent serving the Raleigh, N.C. area. He recently retired from the Army. His background allows him to uniquely understand issues faced by military personnel, but he works with all clients. He is currently a candidate for CFP® certification and seeks to provide objective, commission free advice to clients. Vance was born and raised in Pennsylvania. He is married to Amy. They have a son, Brandon. They enjoy skiing and kayaking.