The potential for passive rental income, profit from property appreciation over the long term, and tax benefits are three of the reasons for investing in rental property.
Depreciation is often cited as one of the biggest benefits of owning real estate because depreciation expense is used to offset the amount of taxable net income a rental property generates.
However, when the time comes to sell, the IRS requires real estate investors to recapture any depreciation expense taken and pay tax. Fortunately, there are ways an investor may be able to defer or even completely eliminate paying depreciation recapture tax.
- Depreciation expense taken by a real estate investor is recaptured when the property is sold.
- Depreciation recapture is taxed at an investor’s ordinary income tax rate, up to a maximum of 25%.
- Remaining profits from the sale of a rental property are taxed at the capital gains tax rate of 0%, 15%, or 20%.
- Investors may avoid paying tax on depreciation recapture by turning a rental property into a primary residence or conducting a 1031 tax deferred exchange.
- When an investor passes away and rental property is inherited, the property basis is stepped-up and the heirs pay no tax on depreciation recapture or capital gains.
What is rental property depreciation recapture?
The IRS allows real estate investors to depreciate residential rental property over a period of 27.5 years, excluding the fair market value of the lot or land, and to use depreciation expense to offset taxable net income.
After the sale of an asset, IRS Form 4797 is used to report depreciation recapture and the total gain or profit from the real estate sale.
The total depreciation expense taken to reduce taxable net income is “recaptured” by the IRS and taxed at the investor’s ordinary income tax rate, up to a maximum tax rate of 25%. Any remaining additional profit is taxed as a capital gain at the rate of 0%, 15%, or 20%, depending on the investor’s federal tax bracket.
How to calculate rental property depreciation recapture
Let’s look at a simple example of how to calculate rental property depreciation recapture and any remaining capital gains tax in three steps:
Step 1: Determine property cost basis
We’ll assume that an investor purchased a rental property five years ago in Waco, Texas, for $107,000, including closing costs like inspection and title recording fees.
At the time the property was purchased, the lot value was $7,000, according to the tax assessor. That means the cost basis of the property – which is the amount that can be depreciated – is $100,000.
Step 2: Calculate depreciation recapture
Over the five year holding period of the rental property, the investor claimed a depreciation expense of $3,636.36 per year, for a total depreciation expense of $18,181.80.
The depreciation expense is calculated by dividing the property cost basis of $100,000 by 27.5 years, then multiplying $3,636.36 by the five years the property was held.
That depreciation expense was used to reduce the amount of taxable net income paid to the state and federal government. When the property is sold, the IRS gets its money back by making the investor recapture any depreciation expense.
The depreciation expense of $18,181.80 is recaptured by the IRS and taxed at the investor’s ordinary income rate, up to a maximum of 25%. If the investor is in the 22% federal income tax bracket (married filing a joint return), the tax paid on the depreciation recapture would be $4,000 ($18,181.80 x 22%).
Step 3: Determine remaining capital gains tax
According to Zillow, the typical home value of a middle price tier home in Waco is $178,523 (as of July 2021).
If the rental property is sold for the median value, the initial gain on the sale would be $71,523. That amount is calculated by subtracting the original property purchase price of $107,000 from the sale price of $178,523.
However, the seller can deduct certain expenses from the initial gain such as closing costs and the sales commission to reduce the gain or profit subject to capital gains tax.
Because the seller listed the rental property on the Roofstock Marketplace, the sales commission was only 3%, for a commission of $5,355.69.
Assuming the seller’s other closing costs were 2% of the sales price or $3,570.46 ($178,524 sale price x 2%), the gain on the sale would be reduced by a total of $8,926.15 (sales commission of $5,355.69 + closing costs of $3,570.46).
The profit subject to capital gains tax is $62,596.85 ($71,523 initial gain – $8,926.15 deductible selling expenses).
Capital gains are taxed at a rate of 0%, 15%, or 20%, depending on an investor’s federal income bracket, according to Topic No. 409 Capital Gains and Losses from the IRS.
If the investor falls into the 15% capital gains rate, the capital gains tax paid on the sale of the rental property in Waco would be $9,389.53 ($62,596.85 profit subject to capital gains tax multiplied by the 15% capital gains tax rate).
Can rental property depreciation recapture tax be avoided?
In our example above, the investor paid $4,000 in depreciation recapture tax and $9,389.53 in capital gains tax, for a total of $13,389.53. Rather than seeing a large percentage of profits go toward taxes, many investors may wonder if there is a way to avoid paying depreciation recapture tax, along with capital gain tax.
For example, some investors consider moving into a rental property and using the home as a primary residence for at least two years before selling.
While a primary residence qualifies for a gain exclusion of $500,000 (or $250,000 if single), the depreciation recapture tax liability does not get wiped out.
So, even though an investor may be able to avoid paying capital gains tax by using a rental property as a primary residence for a couple of years, the tax on depreciation recapture would still be owed when and if the primary residence is sold.
Turning a rental property into a primary residence may also be difficult for a remote real estate investor to do.
For example, if an investor has a high-tech job in San Francisco, moving to a smaller market like Waco, Texas, to turn a rental property into a primary residence and save a few thousand dollars in tax may not be the most practical move.
However, both depreciation recapture tax and tax on capital gain can be deferred by conducting a 1031 tax deferred exchange. When a rental property is relinquished (or sold) and replaced with another investment property within 180 days, an investor may avoid paying tax on depreciation recapture and capital gains.
Instead of paying $13,389.53 in combined depreciation recapture tax and capital gains tax, the investor with the rental property in Waco may decide to use the profits of $62,596.85 from the sale as a down payment for one or more rental homes in different parts of the country.
Is there depreciation recapture on an inherited property?
There’s a saying in the 1031 exchange business that says real estate investors “can swap until they drop.”
In other words, deferred taxes on depreciation recapture and capital gains would eventually become due if the investor sold rental property without reinvesting the gains when he or she was alive.
However, if an investor continues to own rental property until he or she passes away (or drops), the heirs do not pay any deferred depreciation recapture or capital gains tax on an inherited property.
Instead, the property basis is stepped up for the heirs, which is how some real estate investors may be able to build generational wealth. To illustrate, let’s go back to the rental property investor in Waco.
Imagine that instead of selling today for $178,532, the investor continues to hold the property for another three years before passing away.
According to the Consumer Price Index (CPI) from the U.S. Bureau of Labor Statistics (BLS), the 12-month percentage change in inflation is 5.4%. Assuming the rate of inflation remains unchanged, and that housing values do not decline, the property should be worth about $195,087 three years from now.
At the time of the investor’s death, the property basis would be stepped-up to $195,087. The heirs inherit the property, but not the liabilities on depreciation recapture or capital gains tax.
So, even though the investor who passed away has claimed a total depreciation expense of $29,090,88 ($3,636.36 over the eight years of ownership) and has a potential capital gain of about $88,000 before selling expenses, the heirs pay no taxes depreciation recapture or capital gains.
If the heirs continue to own and operate the property as a rental, the depreciation clock is also reset to 27.5 years. The heirs can claim a depreciation expense of $7,094.07 per year, using the step-up property basis of $195,087, to offset any taxable income the rental property generates.
Keeping track of rental property depreciation and capital gains can be much more complicated than the examples used in this article. Cost basis may change due to capital improvements such as new carpeting or a new roof, and property values may rise and fall depending on the normal real estate cycle.
That’s why a growing number of real estate investors use Stessa to help keep rental property finances simple.
Software from Stessa automates income and expense tracking, keeps track of depreciation, and automatically periodically marks to market the property value on the real estate balance sheet. Thanks to Stessa, investors can have a better idea of the amount of owner’s equity at any given point in time, and easily monitor the amount of rental property depreciation and recapture tax.