Depreciation recapture refers to real estate investors being taxed at a maximum of 25% on the lifetime depreciation of a property when an investment property is sold. There is no depreciation recapture tax if a property is sold at a loss.
When a property is sold, the realized gain is calculated by the actual sale price minus the adjusted cost basis. The adjusted cost basis is the initial cost basis of a rental property less the total depreciation taken. The realized gain is then broken up by the total amount of depreciation and the remaining capital gain. The total amount of depreciation is taxed, or “recaptured” at a maximum income tax rate of 25%, and the remainder of the realized gain is taxed at the investor’s capital gains tax rate.
How to calculate depreciation recapture
Calculate your initial cost basis
Your initial cost basis will determine how much you can depreciate over the useful life of the property. For residential real estate, the IRS allows you to fully depreciate a rental property (technically the structure only, not the land) over 27.5 years.
You can calculate your initial cost basis by adding up the initial purchase price less the value of the land, the cost of any renovations or improvements and your closing costs.
If you own a single-family house, you may wish to get an appraisal to separately determine the value of the structure and the land. However, if you own a co-op or condo apartment in a building with many units, the value of any partial land ownership is usually viewed to be de minimis, and thus we’ve been told by accountants that you can usually count that as zero.
This means that for condos and co-ops, you can effectively fully depreciate your entire initial cost basis over 27.5 years, or ~3.6% per year.
Calculate your adjusted cost basis
Your adjusted cost basis is your initial cost basis less the total amount of depreciation you’ve taken over the course of ownership. So let’s say your initial cost basis was $1,000,000 and you’ve held the property for 5 years. At $36,363.64 in depreciation per year that’s $181,818.18 in total depreciation taken over 5 years. Thus your adjusted cost basis would be $818,181.82.
Calculate your realized gain
Let’s say you sell the property in the aforementioned example for $1,200,000 after 5 years. Your gain from the sale will be calculated by the actual sale price minus your adjusted cost basis. So in this example, $1,200,000 – $818,181.82 = $381,818.18.
Subtract depreciation from total gains
The next step is to separate the total amount of depreciation taken from your total realized gain on the sale. This is important because the depreciation that is “recaptured” will be taxed at a different rate vs the remainder, which will be taxed as capital gains.
In our example, the total realized gain is $381,818.18. Of that amount, $181,818.18 was from depreciation (i.e. the realized gain was higher because your adjusted cost basis was lower due to depreciation). So $381,818.18 – $181,818.18 = $200,000.00 which means that depreciation counted for $181,818.18 of the total gains and $200,000.00 was the actual capital gain.
Calculate tax owed
The total amount of depreciation “recaptured” is filed as ordinary income, and taxed at a maximum rate of 25%. The remainder is taxed as a capital gain. Assuming a 20% capital gains tax rate in the above example, the total tax liability would be $181,818.18 x 25% = $45,454.55 in depreciation recapture tax, and $200,000.00 x 20% = $40,000.00 in capital gains tax. The total tax would be $85,454.55.
Pro Tip: There is no depreciation recapture if a property sells for a loss, although the taxpayer may qualify for an ordinary loss per IRC Section 1231. Keep in mind that if a property is held for one year or less, the gain from the sale would be taxed as ordinary income.
Depreciation recapture tax rate
The depreciation recapture tax rate is capped out at 25%, despite the total amount of depreciation taken being filed as ordinary income.
The depreciation recapture tax rate varies depending on the type of asset sold and the taxpayer’s income tax bracket. For example, if the asset sold is a residential rental property, the depreciation recapture tax rate is generally 25% of the gain recognized on the sale. On the other hand, if the asset sold is a piece of equipment used in a business, the depreciation recapture tax rate is typically 20% of the gain recognized on the sale.
In addition to the federal depreciation recapture tax, some states may also have their own depreciation recapture tax.
These state-level taxes may apply to certain types of assets or be applied to all assets subject to depreciation recapture at the federal level.
You will need to complete Form 4797 which is used to report the sale of business property and the amount of depreciation recapture tax owed. You will then need to transfer this information to your tax return on Schedule D, where depreciation recapture tax owed will be reported.
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Depreciation recapture example
Depreciation recapture is calculated by subtracting the adjusted basis of the property from the sale price, and then calculating the depreciation that was taken on the property over the years of ownership. The recapture amount is taxed as ordinary income (capped at 25%), rather than as a capital gain, which is typically taxed at a lower rate.
For example, let’s say you bought a rental property for $200,000 and claimed $50,000 in depreciation deductions over the years. If you sell the property for $300,000, the adjusted basis of the property would be $150,000 ($200,000 – $50,000), and the recaptured depreciation would be $50,000. This recaptured depreciation would be taxed at your ordinary income tax rate up to a maximum of 25%.
The remaining $100,000 in realized gains in the above example would be taxed at your capital gains tax rate, which currently tops out at 20%.
It’s important to note that not all types of real estate are subject to depreciation recapture. For example, your primary residence is not subject to recapture because it is not considered income-producing property. Additionally, certain types of real estate, such as land, are not depreciable assets and therefore are not subject to recapture.
Do a 1031 tax deferred exchange
You can defer capital gains tax or other Federal income tax liabilities, including depreciation recapture, by trading your investment property for another investment property (i.e. you don’t incur capital gains tax unless you sell, thus you avoid selling by doing an “exchange”). This is known as a 1031 exchange, where investors sell their original rental property and roll the proceeds over to a new investment property within certain timelines.
Hold the property till death for a step-up in basis for your heirs
Another common strategy to avoid depreciation recapture or capital gains tax is to simply never sell. If you hold the property until you die, then the cost basis of the rental property “steps-up” in basis to full market value when it is transferred to your heirs. If and when your heirs sell the property, they would owe no capital gains or depreciation recapture tax for any gains or depreciation during your lifetime.
Furthermore, your heirs don’t even have to wait a year to sell to qualify for long-term capital gains tax rates. They can sell immediately after the property is inherited after your death, and if there is any appreciation on the property from the market value when you died to when the sale actually occurred, they automatically get taxed at long-term capital gains tax rates.
The step-up in basis in real estate is one of the greatest tricks used by real estate investors to take advantage of depreciation to reduce their taxable income, and never having to pay depreciation recapture.
Turn the property into your primary residence
You can defer having to pay depreciation recapture by utilizing the property as your primary residence. However, you would still be liable for depreciation recapture should you sell later. However, this strategy makes no sense unless you have a real reason and desire to use the property as your primary residence. That’s because you could just keep it as a rental property and use a 1031 exchange if you really need to sell, or ideally hold it until death to get the step-up in basis for your heirs.
