What is Depreciation Recapture for Real Estate?
When property is sold at a gain, some element of that gain is attributable to depreciation deductions taken in prior years. Under current law, commercial property has a depreciable life of 39 years. This means that the owner of the residential or commercial rental property must deduct 1/39th of the original cost of the building purchased after 1993.
As a result of this depreciation, the adjusted tax basis of the rental property also decreases. Because the gain is the difference between the selling price and this adjusted basis, the depreciation element of the gain is taken into account and taxed as capital gain. This is called depreciation recapture; paying taxes on the gains that are attributed to depreciation. For all property sold on or before May 7, 1997, all capital gain was taxed at 28%. Real estate sold after May 7, 1997 is recaptured at a 25% rate.
When Must You Recapture the Depreciation
When you dispose of property that you depreciated using MACRS, any gain on the disposition generally is recaptured (included as income) as ordinary income up to the amount of the depreciation previously allowed or allowable. This includes any Section 179 deduction claimed on the property and any special depreciation allowance for Liberty Zone property.
To figure any gain that must be reported as ordinary income, you must keep permanent records of the fact necessary to figure the depreciation or amortization allowed or allowable on your property. This includes the date and manner of acquisition, cost or other basis, depreciation or amortization, and all other adjustments that affect basis.
Depreciation Recapture for Residential Property
There is no recapture for residential rental property and non residential real property unless that property is qualified property for which you claimed a special depreciation allowance.
If you rent part of your home, have a home office, or rent a house or other form of property and have taken out depreciation after May 6, 1997, any gain on the sale of your property up to the amount of depreciation you have taken will be taxable at your normal rate up to a maximum long-term capital rate of 25% as long as you have owned the property for at least one year; otherwise it’s taxed at your income tax rate.
Depreciation recapture example 1: Shane sold his house in 2014 for a $125,000 gain. He used his home as a home office and claimed depreciation in the amount of $10,000 on part of his home. Once he sells the house, Shane must pay tax on the $10,000 at the rate of 25%. If he held the property for less than 12 months, the tax rate on the depreciation would be at his ordinary income tax levels.
Note that if you are in a income tax bracket which is higher than the 25% rate, 36% for example, you are still coming out ahead by taking the depreciation deduction.
Depreciation Recapture for Like-Kind Exchanges
If you have a gain from either a like-kind exchange or an involuntary conversion of your depreciable real property, you do not have to report the income if it is carried over to the depreciable real property acquired in the like-kind exchange.
Depreciation recapture example 2: Jeff Sigalla purchases a home for $100,000 and has accumulated $60,000 in depreciation. Jeff’s tax basis is $40,000 ($100,000 – $60,000). Assuming Jeff sells his home and does a 1031 like-kind exchange for another property that has a fair market value of $200,000. The adjusted basis would transfer to the new property and represent the first $100,000 of the new property. Hence, the basis for the new property would be $140,000 ($40,000 basis in the original property in addition to the $100,000 additional amount paid to purchase the new property with the $200,000 purchase price).
When a taxpayer takes a loss on the sale of an asset, there is no depreciation recapture. However, the taxpayer may qualify for ordinary loss treatment under IRC § 1231.
To learn more about Depreciation Recapture and IRC § 1231, visit this publication on Wikipedia.
Understand Depreciation Recapture
You may say to yourself, “Well, I don’t have to worry about depreciation recapture if I don’t elect to use it”. You would be very wrong. The IRS included depreciation recapture in the tax law so you are liable whether you used it or not. You must recapture depreciation you actually claimed or could have claimed for renting out the house.