Understanding Recapture of Depreciation

Understanding Recapture of Depreciation

The Understanding Recapture of Depreciation Before 1997, capital gains and recapture of depreciation were taxed at the same rate. The 1997 tax changes reduced the tax on both capital gains and recapture of depreciation although not by the same amount. The capital gains rate was reduced from 28 percent to 20 percent, but the recapture of depreciation was reduced to only 25 percent.

Everyone initially celebrated the capital gains reduction, but a closer look showed that in almost all real estate situations a significant portion of the gain would be recapture of depreciation, and the gain would therefore be taxed at the 25 percent rate instead of the celebrated 20 percent rate.

The recapture of depreciation consideration is important because many property investors don’t think in terms of adjusted basis. The average property investor owns one or two rental properties, usually rental houses, rental condominiums, or small multifamily buildings. Most of these investors have taken significant depreciation over the years and are appalled when they find out how that will impact their capital gains. Worse, in some cases market values have fluctuated so that perhaps the
current value is approximately what an investor paid originally for the property, but because the adjusted basis is low, the tax liability is high.

Example:
When Carl bought a triplex 15 years ago, the real estate market was strong and getting better. For a few years after he bought the property, the value of his purchase continued to increase, but then real estate values declined sharply. Carl was unable to sell the property for a number of years without taking an unacceptable loss, so he held it through the bad times and now values are rising. Having managed the property for 15 years, Carl no longer wants to be a landlord. Because real estate values are now back to where they were, Carl feels he can get his money out. Let’s say he paid $300,000 for the triplex and can now sell it for $320,000. After selling expenses, Carl figures he will net the $300,000 he originally paid for it. However, Carl has taken the allowable depreciation each year on his taxes, and his adjusted basis currently stands at $190,000. Although Carl has no true gain because he is selling the property for approximately what he paid for it, he will still have to pay taxes on the recapture of depreciation. In this example, the recapture of depreciation is $110,000 that is taxed at 25 percent, a federal tax liability of approximately $27,500 (plus state taxes).

As you can imagine, anyone in a situation similar to Carl’s is going to deeply resent having to pay any taxes at all. It’s usually perceived as an insult added to the injury of bad investment timing. But is it really? Don’t get me wrong; I don’t usually take the IRS’s side on anything, but in this instance a significant benefit was realized.

In the example above, if Carl is normally in the 30 percent tax bracket for income tax purposes, he was able to use that depreciation deduction over the years to shield himself from $33,000 in income taxes. So he actually would be $5,500 ahead. Okay, that doesn’t really make it any better, but it is at least a silver lining in the dark cloud. In any case, because recapture of depreciation is taxed at a higher rate, it is a crucial factor when estimating taxes.