Depreciation Recapture Tax
Most investors are familiar with, and prepared for, the concept of capital gains tax, where taxes are owed on the profit realized from the sale of a capital asset.
However, the taxes that investors often least expect are those imposed when a capital asset, which has been depreciated, is sold.
What is Depreciation?
Depreciation is an accounting method used to represent the decrease in the value of an asset over time, due to factors such as wear and tear, obsolescence, or depletion. While there are different methods of depreciation, this article will explore the most common method: straight-line depreciation.
Straight-line depreciation evenly distributes the cost of the asset over its useful life. Commercial properties are depreciated over a useful life of 39 years, while residential rental properties are depreciated over a 27.5-year schedule. This means that each year, until their depreciation schedule is depleted, an investor can offset their rental income with a depreciation deduction. Even if the property appreciates in value, an investor can still utilize depreciation to reduce the taxes owed on rental income.
The formula for straight-line depreciation is: (Cost of Asset – Residual Value) / Useful Life.
What is Depreciation Recapture Tax?
Depreciation Recapture Tax is one of the highest tax rates related to the sale of real estate, taxed at a flat rate of 25% upon disposition.
This means that in addition to the taxes due on any capital gain, the IRS will tax (recapture) the aggregate value of the depreciation deductions an investor has taken over the life of their investment.
Purchase price: $1,000,000
Sale Price: $1,800,000
Holding period: 16 years
Residual value: $200,000
Depreciation: ($1,000,000 – $200,000) / 27.5 = $29,090.91 per year
Sum of depreciation deductions: $465,454.56
Depreciation Recapture Tax: $116,363.64
(Note: Since land cannot be depreciated, the residual value in this example is the assumed value of the land.)
Defer Depreciation Recapture Tax Utilizing a 1031 Exchange
As is widely known, “no gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.”
The same holds true for the recognition and recapturing of depreciation.
Because the depreciation schedule carries forward in a 1031 exchange, and provided an investor follows the rules specified under Section 1031, they will also be able to defer the taxes associated with depreciation deductions taken over the life of their investment.
Step-up in Cost-Basis
Because the depreciation deduction reduces the cost-basis annually, it’s possible that an asset held for a long time could see its cost-basis adjust all the way to $0.
However, if an investor holds the asset until their death, the estate will receive a step-up in cost-basis: potentially eliminating any taxes due not only on the capital gains of the property but the depreciation recapture as well.
See also: Estate planning using DSTs.
Legal and Tax Advice
Given the complexities of estate planning and tax implications, it is crucial to seek advice from legal and tax professionals experienced in DSTs and estate planning to ensure compliance with relevant laws and regulations.