How Does Depreciation Recapture Work?

Depreciation recapture is popular among taxpayers because it allows them to save on taxes. Instead of accounting for the asset’s value at the date of purchase, you may spread out the cost over time. This strategy allows you to earn tax deductions for its duration. 

If you’re planning on selling an asset that you’ve depreciated to save on taxes, you might want to continue reading. Here, we will explain what is depreciation recapture, how it can lead to a bigger tax bill, as well as how to avoid it.

What Is Depreciation Recapture?

Various types of capital assets and investments may be depreciated, allowing you to take tax deductions and reduce your ordinary income. 

Simply put, by dividing the cost of an asset that you’ve acquired over several years and taking a tax deduction each year for these sums, you will be able to minimize your tax liability. However, this can also reduce the asset’s depreciation-adjusted cost basis. This figure plays a role when computing how much tax you’ll have to pay at a later date when the asset is sold.

In other words, although depreciation can reduce the sums owed at tax time, it can also lead to later tax bills. This is because any gains from the sale of a property will be calculated by subtracting the amount of the asset at its lowered depreciation-adjusted cost basis from the total sale price.

When you lower your cost basis in an apartment, a house, or a condominium, and then sell it after the property has been partially depreciated, you may earn more than anticipated and this may be taxed as ordinary income. 

Deductions and Depreciation in Properties

Any amount owed at tax time can also be affected by your operating and capital expenses. Your operating expenses are costs involved in the day-to-day functioning of your rental properties. This may include your utility bills, property insurance, property taxes, and other expenses related to maintenance. 

Meanwhile, capital expenses are costs you incur with the goal of creating a future benefit such as property upgrades or buying of new equipment. Because capital expenses are investments in your business, they are recorded as assets on your balance sheet, as opposed to expenses listed on your income statement.

In the long run, the asset becomes depreciated and your annual depreciation expenses will be charged to your income statement. This will allow you to enjoy tax deductions. Simply put, capital expenditures can affect your cost basis in any property for purposes of calculating capital gains, but still help you minimize your ordinary income every year because you can deduct for depreciation. 

What Is Depreciation?

As discussed earlier, investment properties are depreciable– from the building (excluding the land it sits on) to the assets in the building.

The IRS has established different asset classes and recovery periods over which the assets can be depreciated, according to their expected useful life. For instance, a residential property that has been placed in service for the last four decades can be depreciated over an assumed useful life of 27.5 years. 

You can compute how much you can deduct in any year by simply dividing your cost basis by the asset’s useful life to arrive at your annual amount of depreciation.

In order to address taxes for real estate sales, the IRS has ordered that any rental property sale must be filed by completing the IRS Form 4797, Sale of Business Property. You may also refer to the guidance published by the IRS on how to complete the form.

How to Avoid Depreciation Recapture

There is actually a way to avoid depreciation recapture and capital gains taxes. A 1031 exchange, which refers to IRS Section 1031 of the tax code, is the best way to reduce your tax liability. 

Under the terms of a 1031 exchange, you should use the proceeds of the sale of a property to invest in another investment property. Simply put, the seller will be able to delay any capital gains taxes on the sale of your investments by selling the property and utilizing the proceeds for a property that is similar in nature to the one you just sold. Your new property should be of equal or greater value than your original holding.

Although you don’t profit from the sale of your property, but you can apply any amount earned toward increasing your real estate holdings.

Final Thoughts

If you’re a rental property owner or a real estate investor, depreciation can be a valuable tool for minimizing your tax liabilities. However, keep in mind that there are limitations on how much you can deduct from your taxes. 

Regardless, with thorough financial and tax planning, you can make your money go much further and roll profits into growing your real estate portfolio. To learn more about depreciation recapture and to optimize your tax position, consult with the tax experts at Lear & Pannepacker, LLP today!