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Depreciation recapture

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.

37 Responses to Depreciation recapture

  1. Mike December 30, 2013 at 1:48 am #

    Michael,

    Let’s assume someone owns several rental properties, they have been accumulating
    losses (including depreciation) on each property over several years, and now they wish to sell.
    Please explain what happens to accumulated depreciation and losses that were never
    applied against personal income because they exceeded the aggregate $25K max deduction each year.

    Thanks!

    • admin January 27, 2014 at 7:54 am #

      Mike,
      All accumulated losses, including depreciation, get released in the year of sale, per property. “Per property” means that only losses attached to the sold properties are released, the other losses remain suspended. The released losses are applied against any other income, without $25k limitation or Passive Losses limitation. Thank you for asking! Michael Plaks.
      See disclaimers

  2. Cindy January 6, 2014 at 7:36 pm #

    How about the rule of if you move into your rental property and live there for at least 2 years. I thought that took away capital gains. Does it not take away the depreciation recapture?

    • admin January 27, 2014 at 7:41 am #

      Good question, Cindy. If you move back to the property for 2 years, you may be able to partially avoid capital gains, however depreciation recapture still applies. Please see the follow-up discussion with Heather regarding the “partially.” Thank you for asking! Michael Plaks
      See disclaimers

    • Heather January 27, 2014 at 7:59 am #

      They changed the rules in 2009, even if you live there for two years, any time period of non qualifying use after 2009 will be not included in our exclusion. So if you rented it out for two years and then lived in it for two years since then, only 50% of your gain would qualify for the 121 tax exemption. Any non qualifying use before 2009 will not be counted.

      • admin January 27, 2014 at 8:21 am #

        Thank you for commenting, Heather. Indeed, the 2009 change undermines the “move back in for 2 years” strategy. This is why I phrase my answers to such questions carefully, saying “may be able.” Your example, however, may be misleading, because it assumes they owned the property for 4 years only. If they owned property for several years, the impact of the 2009 change will not be that dramatic. Thank you again! Michael Plaks.
        See disclaimers

  3. Michael August 3, 2014 at 8:35 pm #

    If my MAGI is greater than $150,000, I cannot claim depreciation on my rental property. I saw an IRS rule that says the IRS assumes you have taken depreciation whether you did or not. Does that apply even when it’s phased out over $150,000 MAGI?

    • admin September 11, 2014 at 4:41 am #

      Michael, I need to correct your opening statement. MAGI above $150,000 does not preclude taking depreciation – it precludes taking an overall loss from rental properties, including depreciation.
      Example: Before depreciation, you show $1k taxable profit on your rental. Depreciation of $3k results in -$2k loss. Your tax return reports zero income or loss, and $2k unused loss becomes “suspended” and is carried as a credit into the next tax year.
      Accordingly, you should be claiming depreciation every year, regardless of your MAGI. When you sell, the IRS will indeed expect you to pay recapture tax on all depreciation. At that point it will be offset by those carry-forward credits for previously unused losses. If you have not claimed depreciation in prior years, you can amend the 3 most recent tax returns, even though technically it is not the correct way to fix the problem. The correct way allows you to go back more than 3 years and “catch up” with all unclaimed depreciation in one year. Unfortunately, this method is very complex and is best left to professionals. Thank you for asking. Michael Plaks.

  4. Jim N August 25, 2014 at 4:47 am #

    Thanks Michael, nice explanations. Two questions:

    1) I make various capital improvements, which I depreciate on a 5- or 7-year basis. When selling the property (rented for the last 13 years) I get to deduct the values of these improvements from my capital gain, but then Uncle will presumably be after me for the depreciation I took (or could have taken) on them. Right?

    2) How do I find out whether the land and the building have appreciated at different rates? I suspect your scenario applies in my case: the building has declined in value and the land has appreciated. Should I hire a tax pro located in the state and city where the property is being sold?

    • admin August 25, 2014 at 7:52 pm #

      Thanks for asking, Jim. The short answer to your #1 is - kind of yes. Unfortunately, the real explanation is impossible via email, especially since I suspect there’s more to discuss than what you stated. I’m concerned about you supposedly depreciating capital improvements over 5 or 7 years, as it may be incorrect. Also, you do not literally get to deduct the improvements from your capital gains.
      As to #2 – I recommend to secure a local Realtor’s opinion. Good luck. Michael Plaks.

  5. Ben Roy September 1, 2014 at 2:09 am #

    Here is my situation:
    Single family house in Middlesex county NJ.
    I purchase Aug 2012 for $325,000. I put $32,500 down. Loan $292,500.
    I live one year. I renovate the kitchen for $11K.
    I depreciated house on 27.5 year single scale.
    From Sept 2013, I rented it.
    I am selling it for $385,000.
    Realtor fee $15,000. Deed transfer $400.
    What would be the tax at sale?

    • admin September 5, 2014 at 3:38 am #

      Ben, thank you for asking. You will have 15% long-term capital gain tax on ($385,000 minus $325,000 minus $11,000 minus $15,400). You will also have 25% tax on depreciation claimed. Hope this helps. Michael Plaks.

  6. Ben Roy September 1, 2014 at 2:10 am #

    In a rental house, if we do not charge depreciation, do we still subject to depreciation re-capture tax at 25% ?

    • admin September 5, 2014 at 3:39 am #

      You pay depreciation recapture tax on depreciation claimed, whether or not you claimed it - so make sure to claim it. Michael Plaks.

  7. Sharon September 1, 2014 at 5:58 pm #

    Michael,

    My AGI is more than 150,000 per year. If I were to sell my rental property next year, it has about $19,000 in passive losses not allowed in previous years.

    I am concerned that the IRS will not “release” the 19,000 in passive losses to offset the depreciation recapture and capital gains taxes because of my AGI being >150,000.

    Is there a Passive Losses limitation at the time of the sale based on my AGI being > $150,000 “or” will the entire $19,000 in passive losses be allowed to offset my taxes in the year of the sale?

    • admin September 3, 2014 at 12:50 pm #

      Good question, Sharon. In the year of sale you get to claim the entire $19,000 of suspended losses, regardless of AGI – assuming that the entire $19,000 is connected to this particular property. It will be a straight deduction on the front of 1040 rather than an offset against capital gain tax. Which is even better for you. Thanks for asking. Michael Plaks.

  8. Chandru September 18, 2014 at 11:52 pm #

    Just trying to solidify this:
    Let’s say accumulated depreciation is $20,000. This is taxed at 25% for a tax liability of $5000.
    But the $19,000 in accumulated passive losses, previously disallowed, can now be applied against the AGI for that year. I.e. If I am I the 31% tax bracket this is worth $5890 in tax savings?
    So the net effect is $890 in my pocket. Did I get this right?

    Chandru

    • admin September 22, 2014 at 11:29 am #

      Thanks for asking, Chandru.
      You’re correct, but under one scenario only: if you sell for the price equal to the “adjusted basis” of the property, i.e. initial cost minus depreciation taken. In the example from my article, that selling price would be $100k – $24k = $76k. Selling above this price generates 15% capital gain tax that you did not factor in. So, if you sell for $100k, it is an additional $24k x 15% = $3,600. Michael Plaks

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