What the heck is depreciation recapture, or unrealized depreciation, or unrecaptured depreciation?
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. You’re looking forward to cashing out the profits! And then you get the tax bill.
You now realize that a lot (or most!) of your “profit” is going to taxes.
Taxes Are Complicated
One of the most confusing parts of having a rental property is understanding the taxes. And especially how those taxes will work when you sell the property. I’ve been a landlord for almost 30 years and I’m still learning about this. And I’ll tell you what: I may have done some things differently along the way if I had understood the tax implications a little better.
Possibly the most complicated part is how you are taxed on the depreciation you’ve taken over the years. The taxes on unrecaptured depreciation (also called 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 a tax professional or real estate attorney. Use this to figure out what you know, and what you don’t know. Then 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. 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 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 12% nominal tax bracket. So they’re benefiting from depreciation at the 10% or 12% rate. Or even 0%, especially with deployments.
Don’t forget, depreciation recapture isn’t the only tax you need to worry about when you sell a house. Read Capital Gains Rules for Military Families to see whether you’ll be subject to capital gains taxes.
The idea behind depreciation is that whatever you’re depreciating is losing value each year. For most types of real property – carpets, computers, cars – that’s true. Our tax code generously allows you to claim that loss of value on your taxes for certain types of property.
But real estate doesn’t usually lose value each year. In fact, real estate often increases in value. If you sell any property 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 at a rate up to 25%. (Even though you maybe were only benefited by 10 or 12% when you depreciated.) This is a very simplified explanation of the math, but good for estimates.
A Very Simplified 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. (The 15% tax bracket no longer exists, but we’ll keep it for purposes of this example.)
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 taxes on the unrecaptured depreciation when. (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. One is undesirable, one might be exactly what you want.
The first way to avoid taxes on unrecaptured depreciation: If you sell at or below the depreciated value, then there is no depreciation to recapture.
The second way to avoid taxes on unrecaptured depreciation: 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.
Depreciation is recaptured at the time of sale, whether you took the depreciation or not. So don’t think, “we just won’t take the depreciation.” I love the logic, but the IRS disagrees…
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) though that isn’t always as big a deal as the media would like you to believe.
The Double (or is it Triple?) Whammy of Unrecaptured Depreciation
Recently, someone said to me, “Depreciation recapture isn’t just a random tax. You’re repaying the money you saved on your taxes in previous years. It’s a wash.” On one level, they’re right. You’ve saved money on your taxes each year by reducing your income on the property by deducting depreciation. Now you’re just repaying all that savings. Except it’s not that simple.
Many military families are in lower tax brackets. Heck, there were many years that my family had ZERO tax liability. So that depreciation taken each year may provide very little value, or it may provide no value at all. But when you sell the house, the recaptured depreciation is included in your income, which often pushes you into a higher tax bracket, meaning you’re paying taxes on that recaptured depreciation at a higher rate.
Here’s a real-but-very-simplified example. In 2017, we sold a house. It had been a rental for 8 years, and the depreciation was roughly $10,000 per year, for a total of $80,000 in depreciation. During those years that it was a rental, we were in the 15% tax bracket, so that $80,000 depreciation saved us $12,000 in taxes over the 8 years. On our 2017 tax return, that $80,000 showed up as income on our tax return, pushing us from the 15% tax bracket to the 25% tax bracket. So when we calculated the depreciation recapture, we paid $20,000 in depreciation recapture taxes. As you can see, $20,000 tax payment for a $12,000 tax savings isn’t exactly “a wash.” It’s a little more complicated than this, but you get the point, right?
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.
Update and An Example:
I was loathe to include an example because this stuff can be so confusing. But I explained it to someone yesterday and I think the explanation is pretty good. So, I’m copying it here:
The Computer Example
It’s a slightly tricky formula. Let me try to explain using an office supply. Let’s say you buy a computer for $1000, and it is on a 10-year depreciation schedule. (It’s not, but it makes the math easier.) Each year, you depreciate it $100 every year, and each year, your cost basis goes down $100. So, after year one, your cost basis in the computer is $900, after year two it is $800, etc. Let’s say you depreciate the computer for 5 years and now it’s cost basis is $500.
For most things in this world, the value/saleable price of the object goes down faster than you depreciate it. Therefore, after 5 years, you might be able to sell the computer for $200, so you wouldn’t have any gain and it wouldn’t be a taxable event
But if for some reason your computer was still worth $600, you’d owe taxes on the $100 between its cost basis and how much you sold it it for. The cost basis is now $500 because you’ve depreciated it for five years.
This is where it gets tricky. Any portion of that taxable amount (in this case, $100) that can be attributed back to depreciation gets taxed at a rate up to 25%. Then, you pay regular capital gains on the amount above that.
A House Example
So let’s take a super-simple house case. Let’s say your original cost basis was $100,000. Houses are on a 27.5 year schedule, so you would depreciate it $3,636 per year. After three years of depreciation, your cost basis is $89,090. You sell the house for $110,000. You’ll pay depreciation recapture taxes on the $10,910 you depreciated the house, and then you’ll pay capital gains (if not exempt) on the $10,000.
Clear as mud, huh?
A little note: This article makes reference to tax brackets that no longer exist. I’ve changed them when it doesn’t change a bunch of math, but left them when the examples are otherwise solid.