What exactly is depreciation recapture in the IRS and how do you calculate it on assets like real estate and property that you may have purchased? If you intend to sell an item that has been depreciated for tax purposes, you should read the following instructions. We’ll look at how depreciation recapture can lead to higher tax payments and how, with a little forethought, you can avoid the impact on your finances and your rental property.
What Is Depreciation Recapture?
Depreciation recapture is a procedure that allows the IRS to recover taxes on a taxpayer’s financial gain from the sale of an asset. Rental buildings, equipment, furniture, and other assets are examples of capital assets. Once the term of an asset has expired, the IRS requires taxpayers to report any gain from the disposal or sale of that asset as regular income. Property and equipment depreciation recapture requirements differ. A capital gains tax is levied on real estate and property depreciation recapture. However, capital gains tax is not included in the depreciation recapture for equipment and other assets. But before we get into recapture, you first understand how depreciation works. We’ll look at how depreciation works in more detail below.
What Assets Are Subject to Depreciation Recapture?
Under Section 1231 of the IRS code, any capital asset held for more than one year might be considered a depreciable asset and is referred to as 1231 property. This is followed by Sections 1245 (capital property that is not real estate or improvements on real estate) and 1250. (real property and land).
In case you’re wondering, assets such as stocks, bonds, mutual funds, commodities, and precious metals are not subject to depreciation recapture since they either have no operating expenses or have minor operational expenses that have no impact on the assets cost basis. In contrast, machinery wears and tears, reducing its market value and utility. Hence, the real property is susceptible to maintenance costs.
Rental Property Depreciation Recapture
One of the most significant distinctions between depreciation recapture for equipment and rental properties is that the final recapture value for properties includes capital gains tax. This means that any profit you make from selling your property will be subject to both capital gains and other taxes. The IRS taxes a portion of your gain as a capital gain, and the depreciation-related component is taxed at a higher rate. The IRS refers to the gain related to depreciation as “unrecaptured section 1250 gain.”
How to Plan for Depreciation Recapture on Rental Property
Now for the good news. When a rental property is sold, passive activity losses that were previously not deductible become fully deductible. This can help to mitigate the tax consequences of the depreciation recapture tax.
A rental property can also be sold in a like-kind exchange to avoid capital gains and depreciation recapture taxes. When a sale is not followed by a purchase, taxes are deferred until a later date.
Depreciation Recapture Examples
The manner in which your gain is recouped is determined by the sort of asset in question. Section 1250 of the tax code applies to real estate property, whereas Section 1245 applies to other sorts of assets. Each specifies the conditions under which recapture can be taxed as regular income rather than at the 25% rate.
Section 1250: Residential Rental Properties
Section 1250 applies to all property purchased or sold after December 31, 1975. It states that any gain on the sale of a property may be taxed as ordinary income in accordance with your marginal or top tax level, based on the lesser of the following:
- The alleged depreciation
- The gap between the sales price or fair market value (if you do not sell the property).
Otherwise, it is liable to the 25% rate rather than the preferential capital gains rate.
Other Real Estate: Section 1245
According to the tax code, Section 1245 applies to property that does not include “a building or its structural components.” A portion of the sale price of this property is taxed as ordinary income to the extent that it exceeds the lesser of:
- The property’s “recomputed” basis, is calculated by adding back deductions.
- The purchase price or fair market value of the asset
Again, the recapture is otherwise taxed at the 25% rate, not the lower capital gains tax rate.
How To Calculate Depreciation Recapture
To calculate your depreciation recapture for equipment or rental property, you must first estimate the cost basis of your asset. The cost basis is the original acquisition price of your asset. You must also know the adjusted cost base. This value is the asset’s cost base less any deductible expenses incurred over its lifetime. You can now calculate the depreciation recapture value of the asset by deducting the adjusted cost basis from the asset’s sale price.
If you paid $30,000 for equipment and the IRS allocated you a 15% deduction rate with a four-year deduction term, your cost basis is $30,000. Your annual deductible expenses would be $4,500. To calculate the adjusted cost basis, multiply four times your annual deduction cost and subtract it from the cost basis. As a result, your adjusted cost base would be $12,000. If you sold the asset for $13,500, you’d have to include any additional costs or commissions. If the fees are $300, you would deduct that amount from the sale price. This figure represents your net proceeds. You would then deduct $12,000 from that value to achieve a $1,500 realized gain.
Read Also: RENTAL PROPERTY DEPRECIATION: How To Calculate It
However, you would not be able to recapture a depreciation if there was a loss at the time the depreciated item was sold. It’s critical to remember that gains and losses are calculated using the adjusted cost basis rather than the original purchase price. The IRS will classify your recapture as ordinary income when you file your taxes. The IRS will also compare the realized gain on the asset to its depreciation expense. The smaller value represents the recapture of depreciation. This also applies to rental homes and real estate.
The same method would be used to determine the adjusted cost basis and deduction expenses for rental properties. The main difference is that your realized gain is affected by the capital gains tax rate and other taxes.
How Much Can You Depreciate Every Year?
The straight-line formula is the most commonly used approach for computing depreciation once again. This entails taking the asset’s cost basis at the time of acquisition and subtracting it from the asset’s adjusted cost basis at the end of its useful life. Then, divide the monetary amount of the cost basis less the adjusted cost basis by the number of years that the asset can functionally service your organization (of years). This will give you the dollar amount of depreciation you can claim per year using the straight-line technique.
However, it turns out that you do not always have to utilize the straight-line method. Under the umbrella of the Generally Accepted Accounting Principles (GAAP), there are three different techniques for computing depreciation. They include decreasing balance, sum-of-the-year digits, and units of production.
How Can I Avoid Depreciation Recapture?
A 1031 exchange, called after IRS Section 1031 of the IRS’s tax code, can help you avoid both depreciation recapture and capital gains taxes if you’re wanting to reduce your tax burden. However, the proceeds of the sale must be used to invest in another investment property under the requirements of a 1031 exchange.
Simply put, as a seller, you can postpone paying capital gains taxes on the sale of your investments by selling a property and putting the money toward a property that is comparable in nature to the one sold and of equal or greater value to your original holding. In actuality, you make no profit when you sell your property and transfer ownership to a new buyer. However, you can apply any proceeds to increase your overall real estate investment holdings.
What if your profit is smaller than your depreciation expense?
If your total recognized gain is less than your depreciation expense, the IRS requires you to calculate the tax payable using your usual rate.
Assume that the real estate market is in a normal declining cycle. Despite the fact that it is a buyer’s market, you opt to sell to a buyer who offers $105,000 for personal or commercial reasons. Because your gain is smaller than your total depreciation tax deductions during the ten years you’ve held the property, your tax is calculated using your usual tax rate:
$99,000 property sales price – $63,640 adjusted cost basis = total recognized gain of $35,360.
Because your depreciation expense of $36,360 exceeds your total recognized gain of $35,360, you will pay tax at your regular tax rate:
Total tax owing = $35,360 recognized gain * the usual tax rate of 24% = $8,486
Is depreciation recapture applicable when a rental property is sold at a loss?
The requirements for recapturing depreciation do not apply if you sell your rental property at a loss. However, even if you lose money on the sale, you will have benefited from being able to take the depreciation deduction of $36,360 over the past 10 years to decrease your taxable income.
The IRS also permits you to carry back a rental property loss by modifying past tax filings. You can also carry your rental property investment loss forward to offset future revenue. The IRS Topic No. 425 Passive Activities – Losses and Credits, as well as Publication 544, describe in detail how losses work for rental real estate activities.
What is Partial Year Depreciation?
We utilized a full year of depreciation in the instances above, which is 3.363 percent of the property value each year. In the real world of real estate investing, however, transactions occur every month of the year.
The month the rental property is put into service is used to calculate partial year depreciation. According to IRS Publication 527, rental property is put into operation when it is ready and available to be rented, not when a tenant takes possession.
That example, if your rental is ready for occupancy on February 1st but a tenant does not sign a lease and move in until April 1st, you can still begin depreciation on February 1st. The IRS also specifies how partial year depreciation works so you don’t make a mistake:
- Full year = 3.636%
- January = 3.485%
- February = 3.182%
- March = 2.879%
- April = 2.576%
- May = 2.273%
- June = 1.970%
- July = 1.667%
- August = 1.364%
- September = 1.061%
- October = 0.758%
- November = 0.455%
- December = 0.152%
Rental property is depreciated at 3.636 percent for each full year of service after your first partial year of service. It is then partially depreciated again depending on whatever month of the year you sell.
Final Thoughts
If you own rental property or invest in real estate, depreciation can help you save money on taxes. Simultaneously, there are limits on how much you can deduct from your taxes and utilize to minimize the amount of money you owe the IRS in any one year. Regardless, with some careful upfront financial and tax planning, as well as an eye toward reinvesting gains in the growth of your real estate portfolio, you can make your money go a lot further.
Depreciation Recapture FAQs
Is depreciation recapture considered income?
Depreciation recapture is normally taxed as ordinary income up to a 25% maximum rate.
What happens if you don’t depreciate rental property?
In essence, you forego the ability to claim a sizable tax break. If you decide to sell the property, you must pay depreciation recapture tax regardless of whether or not you claimed depreciation throughout your property period.
What assets have depreciation recapture?
Depreciation recapture can apply to any depreciable assets for which you have previously earned tax deductions. The method is especially relevant for real estate investors who have generated long-term financial gains on a rental or investment property.
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