How To Avoid Depreciation Recapture Tax On Rental Property

One of the reasons that kept me from investing in rental real estate was trying to understand what all of the terms meant.

Trying to learn this brought back vivid memories of dental school where it seemed that the teachers were speaking a differerent language such as:

• Bruxism
• Edentulous
• Gingivitis
• Impaction
• Malocclusion

When I first started learning about real estate; I could quickly see why so many people give up due to the new terminology including:

• Appreciation
• Amortization
• Capital Gains
• Depreciation
• Cap rate

A major reason why so many doctors and other high-income earners are attracted to real estate is the fantastic tax advantages it offers. One of the most powerful is something called depreciation.

But no discussion of depreciation would be complete without also mentioning something called depreciation recapture taxes.

Real estate investment entices high-income professionals primarily due to its unbelivable tax benefits. And of the ones that prominently stands out is depreciation.

However, what the IRS giveth, the IRS taketh. So a comprehensive understanding of depreciation along with a related concept, depreciation recapture is necessary.

And in this article, we’ll highlight everything you need to know about the depreciation recapture rate along with depreciation in order to help lower your tax burden.

Before we take a closer look, remember to check with your tax advisor before using any of this information (don’t take this as financial advice).

Key Takeaways

• Depreciation allows real estate investors to deduct property costs over time, thus reducing taxable income.
• If you sell a rental property for a profit and have taken depreciation deductions, your property is subject to a deprecation recapture tax.
• Depreciation recapture tax is calculated using the original purchase price, accumulated depreciation, and sale price.
• The rental property depreciation recapture tax rate is typically 25%.
• A 1031 exchange is a strategy that allows you to defer depreciation taxes if you use your property’s sale profits to purchase another investment property.
• Converting a rental property into a primary residence can qualify for IRS Section 121 exclusion, reducing tax liability.
• If your rental home was your primary residence for a qualifying period, you could avoid depreciation taxes with a Section 121 exclusion.

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How To Avoid Depreciation Recapture Tax On Rental Property: Expert Strategies Explained

Owning residential real estate can be a lucrative investment, but it also comes with responsibilities, including managing taxes related to depreciation.

Depreciation allows rental property owners to deduct the cost of the property value over its useful life, thus, reducing taxable income. This is great, especially if you’re a high income earner searching for ways to lower your tax bill. 

If you want to learn more about how depreciation in real estate works, check out this video:

But what happens to all of that depreciation expense once a property is sold?

Typically, the previously claimed amount of depreciation may be subject to depreciation recapture, which could result in a significant tax liability for the property owner.

The good news is that there are strategies that investors can use to minimize or avoid this depreciation recapture tax. One popular example a 1031 exchange, which allows property owners to defer depreciation recapture tax and capital gains tax by reinvesting the proceeds from the sale of your property into a like-kind property.

If you haven’t realized by now, the ULTRA-wealthy NEVER sell property and pay little to no tax.  And in this article, we’re going to discuss how they do it.

What is Depreciation Recapture?

Depreciation recapture is yet another way that our friends at the Internal Revenue Service (IRS) collect taxes on the financial gains made from the sale of an investment property.

When claim depreciation deductions on property then the value of that property decreases over time. However, when you sell the property at a price higher than its depreciated value, the IRS requires you to pay taxes on the difference.

And this difference is considered “recaptured” depreciation.

How Does Depreciation Recapture Work?

When you invest in real estate, you’re able to reduce taxable income by taking annual depreciation deductions. These deductions are based on the property’s useful life. For instance, residential property owners are able to write off their property with straight-line depreciation over 27.5 years.

In order to calculate the depreciation recapture tax on rental property, you need to consider the:

• original purchase price
• accumulated depreciation
• final sale price of the property

Here’s the formula for calculating the recaptured depreciation:

(Original Purchase Price – Accumulated Depreciation) + Final Sale Price of the Property = Realized Gain

This realized gain is subject to depreciation recapture tax.

Depreciation Recapture Example

Here’s an example of how depreciation recapture affect rental properties:

1. Dr. R purchases a single family home for $300,000, excluding the land value.
2. He claims $100,000 in depreciation deductions over time.
3. The adjusted cost basis of the property becomes $200,000 (original cost – depreciation).
4. He sells the property several years later for $350,000.

In this case, Dr. R has a capital gain of $150,000 (sales price – adjusted cost basis), out of which $100,000 is subject to depreciation recapture tax. The remaining $50,000 is subject to capital gains tax.

For most taxpayers, the current depreciation recapture tax rate is 25%.

With regards to the capital gains tax the rate varies depending on your overall income:

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3 Best Ways to Avoid Depreciation Recapture Tax on Rental Property

When dealing with rental properties, it’s essential to understand the potential tax implications, such as depreciation recapture tax. Here are a 3 strategies to minimize or avoid this tax liability.

#1. 1031 Exchange

A 1031 exchange, also called a like-kind exchange, is an effective way for investors to defer or avoid depreciation recapture and capital gains taxes on the sale of an asset until they buy a new one. This is a useful tool for those who want to improve their rental property because it lets them put money from the sale of one property toward the purchase of another one without having to pay taxes on the sale.

Both the property being sold and the one being purchased must be like-kind properties for a 1031 exchange to be possible.

This means that they must both be real estate investments and be used for business or investment purposes. 

The exchanged property must be of equal or greater value, and specific rules must be followed to qualify for the tax benefits:

• Within 45 days of selling the initial property, must have up to three identified properties to replace it with.
• You have 180 days to buy one or more of the properties listed.

#2. Convert Your Rental to a Primary Residence

The second way to avoid depreciation recapture tax is by converting your rental property into your primary residence. When you eventually sell the property, you may be able to qualify for the IRS Section 121 exclusion.

If you’re a single filer, you’re able exclude up to $250,000 of capital gains from the sale of your home from your income or up to $500,000 for married couples filing jointly.

You’re able to qualify for this exemption if you:

• Live in the home for at least two years in the five-year period before you selling it.
• Not have used the exclusion for another primary residence within the past two years

Keep in mind that the exclusion can significantly lower or remove your depreciation recapture tax altogether.

#3. Use Tax Loss Harvesting

Tax loss harvesting refers to a technique aimed at minimizing tax burden by selling both profitable and under performing investments. This technique comes into play when there’s been a decline in your asset value and you decide its time to sell – ideally within the same tax year as selling your rental property.

The aim here is to reduce capital gains for that particular year, thereby limiting/elimination any depreciation recapture taxes owed.

For example, if you make a profit worth $100k compared to your home’s depreciated value, it may lead you to paying up to 25% in depreciation recapture taxes.

However, in the event of you suffering $75k worth of losses from the stock market, then selling those stocks will “harvest” all but $25k from the profits. You’d only pay 25% of $25,000 instead of 25% of $100,000. As with every financial decision, it’s vital to evaluate whether it’s beneficial before employing the tax loss harvesting method.

Plan For Depreciation Recapture

You can avoid a large tax bill by anticipating depreciation recapture taxes ahead of time.

Before you sell your rental property, review these 3 options and consider whether performing a 1031 exchange, turning your rental into your primary residence, or offloading other investments using tax loss harvesting aligns with your financial goals. 

FAQs

Do I have to recapture depreciation on rental property?

Yes, when you sell a rental property, you must pay tax on the depreciation previously claimed. 

What happens when you sell a fully depreciated rental property?

If you sell a fully depreciated rental property, you could still owe the IRS. This is because the IRS consider the money you saved from claiming depreciation as income when you sell the property.

What happens if sold rental property did not take depreciation?

If you didn’t initially claim depreciation on your rental property, the IRS still acts like you did. What this means is that when you sell the property, you may owe money on the depreciation you should have taken.

What triggers depreciation recapture?

When you sell a rental property, the depreciation recapture is triggered.  This is how the IRS is able to get back some of the money you saved via depreciation over the years.

Does all depreciation have to be recaptured?

The short answer is yes. All of the depreciation that you either claimed or could have claimed must be recaptured when you sell it. 

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