***This article is focused on federal law, the laws in your state may differ.  The concepts presented here are simplified, written for common situations, and may not fully address your tax situation. This article should not be taken as tax advice for your tax situation. It is written for informational purposes only. ****

Depreciation is great for rental property. It creates a deduction that can be used to offset the rent collected and reduce your annual tax bill. That greatness lasts until you sell the rental property. The theory is that your rental property gets worn out over time so you can take a deduction for that loss of value each year. Or more broadly that you can deduct the cost of durable business equipment and assets according to the federal depreciation schedules. The initial number used to determine the amount of deduction each year is the depreciable basis. The amount was determined when the property was placed in service. 

But it turns out that rental property often doesn’t lose value. As one might expect, the IRS thinks if it didn’t lose value then you should pay back the tax benefits you had over time when you sell. Actually, Congress told the IRS to think that way, so if that disturbs you, then you know to whom you should speak. Paying back the depreciation benefit you have taken over the years is often called depreciation recapture. 

There is some stuff you should know before getting to the Good, Bad, and the Ugly. Depreciation lowers your basis in your property. Let’s look at a simplified example. Say your starting depreciation basis for a condo is $100,000. You have it for a few years and then you sell it for $200,000. Let’s say your depreciation totaled $50,000 and there were no other basis adjustments. Instead of: $200,000 – $100,000 = $100,000 gain, the equation is $200,000 – ($100,000 – $50,0000) = $150,000 gain. (I think they call that algebra, but it has been a long time.)

$50,000 of that gain is taxed at your ordinary rate -basically your marginal tax rate, but only up to a 25% max rate. Think tax bracket. $100,000 of that is taxed at the long term capital gains tax rate if you held the property at least year and a day. More about these rates later. 

The Good

I have to stretch a bit for this. If you have a loss, meaning the sale proceeds are less than the adjusted basis after the depreciation adjustment, then you won’t be paying depreciation recapture. Yay! Who would have thought losing money would pay off. 

Also, if your gain is less than the depreciation recapture should be, the total depreciation taken, then you only pay depreciation recapture up to the amount of the gain. So less depreciation recapture, but that pretty much usually means you didn’t do all that well on the sale. 

The tax rate for depreciation recapture, as stated above, is your ordinary tax rate but at a max of 25%. So if your marginal tax rate is 22% and all that gain fits into the 22% bracket, then you’ll pay 22%. But if you are way up at a marginal tax rate of 37% then you are past the max and your gain is only taxed at 25%. Yes, for those of you who are in doubt, it is good to be rich. 

And finally we’ll cover a few ways to defer depreciation recapture and capital gains taxes- meaning you put off paying the taxes. One, don’t sell the property. And two, sell the investment property through a 1031 exchange and purchase a second investment property. The 1031 exchange process has strict rules to follow in order to be successful. We’ll cover a third later, under Ugly. 

The Bad

 As you may have noticed already, the depreciation recapture portion of capital gains is taxed at your ordinary rate, which is normally higher than your long term capital gains tax rate. The long term capital gains tax rate is less than your ordinary rate and maxes at 20%. Those of us who are good at math have already noted that a 25% max is higher than a 20% max. In highly technical tax terminology, I call that “bad”. 

You might be thinking at this point that, “hey, I’ll qualify for the section 121 exclusion and I’ll have capital gains excluded from taxation due to the sale of a primary home even though I did turn it into a rental, so I don’t have to worry about any of those taxes”. You may even qualify for the “military exclusion” or what I call the exception for the 5 year rule to exclude capital gains from taxation for the sale of a main home due to qualified official extended duty. Yes, I’m that guy. (See IRS Pub 523 if you are confused. Still confused, talk to a MTEA  tax professional.)

But here is the bad again. Even if capital gains are excluded from taxation, the taxes on the portion of gain attributed to depreciation, the depreciation recapture, still has to be paid. I’ll say it again: You Still Pay Depreciation Recapture if you qualify to exclude the capital gains from taxation. Yeah that sucks, but wait until you hear about the ugly.

The Ugly

First ugly. You might be thinking at this point that since depreciation is allowed and not required,  I just won’t depreciate so I don’t have to worry about depreciation recapture when I sell. But here it gets ugly. If you didn’t actually depreciate because the tax code says it is allowed instead of required, you still have to pay depreciation recapture. Even though you didn’t depreciate, even though you didn’t get any tax savings, you have to pay back the tax savings you didn’t get by paying depreciation recapture on the sale. There is some good in this ugly. It can be fixed. The process to fix is usually a Change of Accounting Method using Form 3115. I strongly recommend consulting a tax professional to correct depreciation errors. 

Second Ugly. Well, this one isn’t pleasant. But a way to avoid depreciation recapture and capital gains entirely is to die. At your death the basis of your rental property moves up from your basis to fair market value. If your heirs sell the property before there are gains from that new basis, then they pay no taxes on the sale. While this can be an important part of tax planning and estate planning, I suggest not rushing it. They call this a step-up in basis. You can use that term in parties and be cool like me. 

 

That’s it, the good, bad, and ugly about depreciation recapture. Okay, maybe I oversold the good. Depreciation recapture is something landlords need to be aware of and something that needs to be factored into their tax planning. Sometimes military landlords have unique tax planning opportunities. For example, knowing about depreciation recapture and knowing that you’ll be in Combat Zone Tax Exclusion (CZTE) zone might present a good opportunity to minimize your tax liability on the sale of a rental property through the timing of the sale and a lower tax bracket. MTEA tax professionals know about opportunities like this because we know about military life.