You’ve owned a rental property for a few years, and it’s worked out pretty well. You’ve made a little bit of money most years, and you’re looking forward to cashing out the profits. And then you get the tax bill, and realize that most (or all!) of your “profit” is going to taxes.
One of the most confusing parts of having a rental property is understanding how the taxes will work when you sell the property. I’ve been a landlord for 20 years and I’m only fully understanding this now. (I’m a little slow sometimes.)
Possibly the most complicated part is how you are taxed on the depreciation you’ve taken over the years. The taxes on depreciation recapture can make the difference between a profitable or not profitable rental experience. Because these taxes are paid at the sale of the property, not understanding them and including them in your profitability analyses can mean that your numbers are wrong. Failing to account for taxes can mean that you think your property is more profitable than it actually is.
Note: I’m not an accountant or real estate attorney. Use this to figure out what you know, and what you don’t know, and consult with your professionals to see how this applies to your specific situation.
Every year, you depreciate your rental property. Depreciation is a loss on the value of your property, but it only exists on paper. Depreciation is only on the building — you can’t depreciate land. The land portion of your home is often about 20% of the total value, while the structure makes up the other 80%. If you don’t know the percentage for your property then check your property tax statement or your last appraisal.
If you’re not depreciating, you should be… because the IRS assumes that you’re depreciating, and they’ll tax you no matter what you’re doing. You’ll pay the recapture taxes whether you actually took the depreciation or not.
Depreciation reduces your overall tax liability by reducing your profit or boosting the loss on your rental property. For many landlords, this depreciation is the only reason they’re getting a tax benefit from owning a rental. The amount of depreciation depends on the value of your house (not the land), and the value of the depreciation is based upon your tax bracket. Many military families are in the 10% or 15% nominal tax bracket, so they’re benefiting from depreciation at the 10% or 15% rate (or 0%, especially with deployments.)
The idea between depreciation is that whatever you’re depreciating is losing value each year. That isn’t always true for real estate. In fact, real estate often increases in value. If you sell for more than the depreciated value of the property, you’ll have to pay back the taxes that you didn’t pay over the years due to depreciation.
However, that portion of your profit gets taxed not at the capital gains rate but at a flat 25% rate. (Even though you maybe were only benefited by 10 or 15% when you depreciated.) This is a very simplified explanation of the math, but good for estimates.
Here is an example: Let’s say you had a house that had a house value (not land) of $100,000 when you put it into service as a rental. You’d take about $3,600 in depreciation each year. If you are in the 15% tax bracket, you’ll pay $540 less in taxes each year due to depreciation.
After five years, you sell the house for more than you paid. In calculating the taxes on the sale, you’ll take the $18,000 you’ve taken in depreciation, and pay $4,500 in recaptured depreciation taxes on the sale. (Again, this is the extremely simplified explanation of the math. It’s actually much more complicated.) You pay $4,500 in recaptured depreciation taxes even though you only benefited by $2,700 in taxes during the years you were depreciating!
When you’re dealing with a larger property value, or more years, the depreciation recapture taxes that will be due at the sale can add up to a lot. We own a house that we have been depreciating at almost $10,000 per year. After 10 years of rental, we’ll owe about $25,000 in depreciation recapture taxes, plus the other taxes that will apply.
The More Complex Math
Here’s the part of the post where I was going to put in many examples and explanations and charts and pictures about how this actually works. However, there are too many variables and I could not come up with a single example that was clear enough that it didn’t create more questions than answers. You’re going to want to get a tax professional to handle this in the year that you sell. Go ahead and meet with that person now and have them explain how your situation will unfold. I do not advise doing this yourself or using a tax preparation program.
I apologize that I couldn’t include more concrete examples, but I just didn’t think it would be responsible.
Can You Avoid Depreciation Recapture Taxes?
There are only two ways to avoid depreciation recapture taxes. Both of them are bad for you, but one of them might please your heirs.
If you sell at or below the depreciated value, then there is no depreciation to recapture.
If the house becomes part of your estate after death, the cost basis in the house is reset.
You can delay the depreciation recapture taxes on a sale by reinvesting the proceeds into another property, in a slightly-complicated tax move called a 1031 Exchange, or a Starker Exchange. If this interests you, you need to do a LOT of research and learn all the rules and details. I recommend BiggerPockets.com’s 1031 Exchange Guide: Basics, Resources, and Intermediaries.
You can NOT avoid depreciation recapture taxes by making the property your principal residence. You will still owe the taxes when you sell the property.
Be sure to investigate the other taxes you may have to pay when you sell the property. This may include state and/or local income taxes to the state where the property is located and/or capital gains taxes. The sale of property might also bump you into the dreaded Alternative Minimum Tax (AMT.)
Taxes are an important part of the profit and loss equation of owning a rental property. There are many types of taxes that you may owe when you sell the property, including the taxes on the recaptured depreciation. Understanding these taxes from the beginning will help you make a much more accurate analysis of the value of your investment property, and will help you make better decisions about your property.