How to calculate depreciation recapture on rental property

Taxation on investment properties works differently than the way that you are taxed for everyday earnings and income. Before purchasing a real estate holding as an investment, it’s wise to educate yourself on these differences.

Capital Gains Vs. Ordinary Income

Owners of rental properties are subject to two types of interrelated, but separately calculated taxes: capital gains and ordinary income.

Capital gains occur when profits are made on the sale of an asset such as a property, and come in two versions: Specifically, short-term (when an asset has been held for a year or less) and long-term (when you’ve held an asset for more than a year) gains.

• Short-term capital gains: These are taxed in similar fashion as the ordinary income (revenue from business or professional activity) that you earn in any given year, based on your individual tax bracket.
• Long-term capital gains: These are typically taxed at lower rates than short-term gains and ordinary income and are based on their own alternate tax brackets.

In essence, if you purchase a property and then flip or sell it later for a profit, you can expect to pay short-term (under 1 year of asset ownership) or long-term (over 1 year of asset ownership) capital gains on the sale of your real estate. Likewise, if you earn money from the rental of any given property, that money will be taxed as ordinary income according to your tax bracket.

Deductions And Depreciation

Note that any sums owed at tax time can also be impacted or reduced by operating and capital expenses. Operating expenses are costs required for the day-to-day functioning of your rental property business, such as those related to maintenance and upkeep. Examples include:

• Utility bills
• Property taxes
• Property insurance

Capital expenses are costs that you incur with an eye toward creating future benefit, like the purchase of new equipment or property upgrades. Each is treated differently for accounting purposes.

Worth noting here: Capital expenses are recorded as assets on your balance sheet as opposed to expenses on your income statement, being investments in your business by nature. Over time, the asset is then depreciated, with annual depreciation expenses charged to your income statement, helping you enjoy deductions for tax purposes. In other words, capital expenditures can impact and influence your cost basis in any given property for purposes of calculating capital gains, but still help you reduce your ordinary income on a year-to-year basis because property owners can deduct for depreciation.

If you’re like most investors, you own a rental property to make a profit. They often earn cash flow as long as you can keep them occupied. The property may also appreciate leaving you with a nice profit when you decide to sell.

Before you sell the property, though, you’ll need to understand what happens when you sell a rental property. Most importantly, understand the depreciation recapture taxes as it often sneaks up on investors in the final hour.

Depreciation recapture tax is a tax on the depreciation you wrote off while you owned the property. Once you sell, Uncle Sam wants his portion of the expenses you wrote off and now earn back by selling the property.

Table of Contents:

What Is Depreciation On A Rental Property?

As a real estate investor , you can claim depreciation on the rental property, even if its value increases. The deprecation exists on paper only – and only for the IRS. You may only depreciate the building, not the land.

On average, the land takes up 20% of the home’s value , but check your tax bill or latest appraisal for accurate numbers. Each property has a different land and building value. For example, if you bought a home for $200,000 and the tax bill shows the land is 20% of the home’s value, your depreciation cost basis is 80% of the purchase price or $160,000. You can’t depreciate the $40,000 land value.

You may depreciate the property as soon as you ‘place it in service.’ If you buy the home on June 1 but take 6 months to fix it up and advertise its availability, you can’t start depreciating it until Jan 1 or the date you put it in service. This date applies whether or not you have tenants – as long as you list the property for rent, it counts.

You depreciate the home over its useful life, which according to the IRS is 27.5 years or 3.63% of the cost basis annually. Your cost basis is the cost of the home minus the land’s value plus the cost of any improvements that add value to the home. You may not include the cost of getting the loan , rent paid prior to closing, or fire insurance premiums, though.

What Is Depreciation Recapture?

The depreciation deduction lowers your tax liability for each tax year you own the investment property. It’s a tax write off. But when you sell the property, you’ll owe depreciation recapture tax.

You’ll owe the lesser of your current tax bracket or 25% plus state income tax on any deprecation you claimed. Here’s the kicker – even if you didn’t claim the depreciation expense, you’ll pay depreciation recapture tax, so make sure you take the deduction when eligible.

The only time you don’t owe depreciation recapture tax is if you sell the home for a loss. Let’s say the market dropped drastically and you can’t afford to keep the home any longer. You cut your losses and sell for what you can, selling for an amount less than you paid originally. You claim a loss on your taxes and don’t owe a recapture tax.

Depreciation Recapture Tax is Not As Complex As You Think

Provided you sell the property for more than you bought it for, you are liable for depreciation recapture tax.

To work out this amount, you simply need to calculate how much depreciation was claimed during your ownership of the property, and multiply the total by your ordinary income tax rate.

So, if you owned the property for 10 years, your income tax rate is 18% and you claimed $40,000 in depreciation over those 10 years, the depreciation recapture tax would be $7,200 (ie $40,000 * 18%)

Depreciation Recapture Example

Let’s assume you purchased a rental property for $200,000, claiming a total deprecation of $55,000 over 10 years, and then sell the property for $240,000. Now let’s dissect the numbers in a relatively simple format.

• Rental Property Original Purchase Price: $200,000
• Total Depreciation Claimed over 10 Years: $55,000
• Original Cost Basis: $160,000

Step 1: Workout The Rental Property Depreciation Recapture Tax Amount

If your ordinary income tax level is 20%, then you simply multiply the total depreciation amount ($55,000) by 20%.

• Income Tax Level: 20%
• Total Depreciation: $55,000
• Depreciation Recapture Tax = $55,000 * 20%
• Depreciation Recapture Tax = $11,000

Step 2: Workout The Capital Gains Tax Amount

This is where the adjusted cost basis of the property becomes important. It has a direct impact on the total capital gain.

• Original Cost Basis: $160,000
• Adjusted Cost Basis: Original Cost Basis – Total Depreciation
• Adjusted Cost Basis: $160,000 – $55,000
• Capital Gain = Rental Property Sales Price – Adjusted Cost Basis
• Capital Gain = $135,000
• Capital Gain Tax Amount = $135,000 * 15%
• Capital Gain Tax Amount = $20,250

Step 3: Add these two numbers together to get the total tax owed

• Total Tax Payable = Depreciation Recapture Tax + Capital Gains Tax
• Total Tax Payable = $11,000 + $20,250
• Total Tax Payable = $31,250

What portion is capital gains tax, and what portion is depreciation recapture tax?

The depreciation recapture amount is determined by the total amount of depreciation that you claimed during your ownership of the property, and your personal income tax rate.

The rest of the ‘gain’ is taxed at the appropriate capital gains tax rate.

Assuming you hold the property for more than a year, your long-term capital gains tax rate will either be 0%, 15% or 20%, depending on the amount of the capital gain and your marital status.

The table below provides a breakdown, showing how to work out the capital gains percentage, depending on how much money you make when selling the rental property.

Rental Property Capital Gains Tax Rate Table

The IRS Depreciation Rules

Who does the IRS assume depreciation a rental property? If the home meets the following requirements, it qualifies:

• You own the property outright or with a mortgage on it
• You own the home as a part of your business (aka you rent it out)
• The property has value
• The property has a useful life of at least one year

If you buy a rental property and sell it within the same year, you can’t depreciate it and don’t have to worry about depreciation recapture tax.

Final Thoughts

Rental property depreciation gives you greater cash flow while you own a property and delays the taxes you owe until you sell a rental property. It’s like an interest-free loan, but keep the taxes in mind. When you sell the property, you’ll realize a lower profit because you’ll owe the taxes. There’s no getting around it, even if you don’t take the deductions, so take advantage while you can and be aware of the tax liability when determining the price to sell the home.

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