What the heck is depreciation recapture?
Some people simply enjoy self-torture. They do their own taxes. If you are one of them and you never heard of “depreciation recapture” – it’s time to get an accountant. If you already have an accountant and she never discussed “depreciation recapture” with you – you need a new accountant. Either way, it’s a good idea to learn some basics. Especially now, when the rules of the game changed. Don’t you want to be ahead of the game?
Let’s start with an example. You bought a rental house in 1995 for $100K. In 2003, you sold it for $150K. If life was simple, you could get away with the following calculation: your profit is $150K minus $100K equals $50K. You held the property more than a year, therefore it’s “long-term”. The newest long-term capital gain tax rate is 15%. Take 15% of $50K which is $7,500 of tax.
Unfortunately, it is not so simple, and the correct tax is way higher. How come? Because of depreciation. Every year since 1995 you were depreciating the house, right? What did it do to your taxes? Correct, they went down. But if you think you got a free ride from the government, think again. What you were saving on depreciation year after year, comes back to you now – when you sold the property. All that nice depreciation has to be added back to your capital gain. For simplicity, let’s estimate that your annual depreciation on that $100K house was $3,300 per year. You had it for 9 years, so you received $3,300 times 9, or $30K of depreciation. Sorry, this is extra $30K of taxable gain!
It gets worse. You would assume that you owe extra 15% of $30K or $4,500 in taxes, right? Wrong! Welcome to the “depreciation recapture”. Unlike “normal” capital gains taxed at 15%, the recapture portion is taxed at 25%. You owe 25% of $30K, or $7,500 – as much as the capital gain tax on the $50K appreciation! Believe it or not, your taxes just doubled! By the way, you’ve heard of 1031 exchanges, haven’t you? Next time, you may want to pay more attention.
If you’re tired at this point, I don’t blame you. Albert Einstein, the famous physicist, once noted that the hardest thing in the world to understand was income tax. The IRS is doing a great job proving his point.
For those who have the stomach to continue, let’s do the math more accurately. You could not depreciate the entire $100K. You (or your accountant) were supposed to divide the initial purchase price between the building and the land. Under a typical 80/20 ratio, it would be $80K for the house and $20K for the land. Why does it matter? Because, unlike the buildings, land is not depreciated. Instead of $3,300 annual depreciation on $100K, you were actually entitled to “only” about $2,700 depreciation based on $80K. Yes, less depreciation does mean that you owed more taxes in the past. The good news is that the depreciation recapture is also reduced. $2,700 times 9 years is about $24K, and 25% recapture tax on $24K is $6,000. Still huge, but less than the $7,500 we calculated before.
If reducing the recapture tax sounded like a victory, it really was not. Yes, we pay less recapture tax now, but we had to pay more “regular” taxes in the years before, due to reduced depreciation. It’s a wash. If so, than what’s the point? Wait please! We’re not done yet.
We need to re-examine the breakout between the land and the building. Up to this point, we assumed that they appreciated equally. The original $80K building appreciated 50% to $120K, and the original $20K land went up by 50% to $30K. If so, the previous calculation stands. But what if the building, instead of going up, went down in value? What if it is now appraised at $50K? What used to be an $80K house on $20K land is now a $50K house on $100K land. Yes, it does not happen daily. But is it possible? Yes! Beneficial? You bet! Under this scenario, the math will be quite different. Saving the technical details for the crazy accountants, let me just say that the 25% recapture tax may end up replaced by the 15% capital gain tax. The difference? In our example, it would be about $2,400. And if you happen to qualify for the rock-bottom 5% capital gain rate, you’d save twice that much! Don’t know about you, but I would take it.
Let’s sum up the story. You did make $50K on that house, didn’t you? You will have to share with Uncle Sam, make no mistake about it. But also, don’t make the mistake of sharing too much! After all, your tax professional – if he is good – can be useful.