Annual depreciation expense is one of the costs investors look forward to utilizing. It helps lower one’s current liabilities, and who doesn’t like reducing their tax bill? 

Unfortunately, many investors forget to consider what happens to this depreciation expense when selling their property. Instead, they will factor in the usual capital gains tax, pay their dues, and be surprised when their tax advisor informs them that additional tax is owed.

Before selling your rental property, understand all tax implications, especially depreciation recapture tax. By the end of this post, you should understand how depreciation works, how the Internal Revenue Service (IRS) recaptures it and taxes you when residential rental properties are sold, and how you can avoid this tax altogether. 

What is rental property depreciation?

Rental property depreciation is a process by which the value of a rental property is decreased over time. This decrease in value is due to wear and tear, obsolescence, or other factors. The depreciation of a rental property can be used as a deduction on your taxes, which can help to reduce the overall cost of ownership.

The depreciation expense is deducted annually on your tax return and is treated as a noncash expense. As an investor, you can claim the asset’s depreciation for the year to lower your current tax liability without parting with any actual cash.

When it comes to rental property, the IRS allows investors to claim depreciation on residential investment property for 27.5 years, which is the expected useful life of a property for tax purposes. For instance, let’s assume you bought a rental property with a building value of $300,000. The annual depreciation expense for this property will be $10,909.09: 

• Value: $300,000
• Useful life: 27.5 years
• Depreciation expense: $300,000 / 27.5 = $10,909.09

Using our example, you can claim $10,909.09 as an expense in your taxes through the property’s useful life or until its sale. However, this useful life and depreciation apply only to the building, not the land, since land does not lose value and has an unlimited life.

What happens with depreciation when you sell a rental property?

Depreciation recapture is how the IRS collects back (recapturing) income tax from profits investors realize upon selling a property that previously helped offset their income taxes through depreciation. Depreciation recapture tax is calculated by multiplying the depreciation expense claimed by your current tax bracket rate or 25% (capped at this rate for high-income earners) and reported using Form 4797. 

The IRS also requires you to pay tax on capital gains. You pay long-term capital gains taxes from the profit of selling the property, assuming you hold it for more than a year.

Depreciation recapture tax is determined by how much depreciation deduction you claimed over the life of the property and your income tax rate. Capital gains tax is dependent on the profit of selling the property.

How depreciation is recaptured and taxed

Let’s assume it is 10 years after the purchase of the property in our previous example, and you have sold it for $500,000. Let’s also assume your ordinary tax bracket is 22%. Your depreciation recapture tax amount will be:  

• Holding period: 10 years
• Total depreciation in 10 years: $109,090.90
• Tax bracket: 22%
• Depreciation recapture tax = $109,090.90 x 22% = $24,000 

Since the capital gain is taxed separately from depreciation recapture tax, it also has varying rates, ranging between 0%, 15%, and 20%, depending on one’s federal income tax bracket. Assuming you fall under the 20% category, using our example, your capital gains tax will be: 

• Original purchase price: $300,000
• Sale price: $500,000
• Capital gain: sale price – purchase price
• Capital gain: $500,000 – $300,000 = $200,000 taxable capital gain
• Capital gains tax: 20% x $200,000 = $40,000 tax due to capital gain

This example might be considered “worst case” because the property’s cost basis often changes over time.

For example, assume an investor purchased the above rental property for $300,000, incurred closing costs of $4,000, had capital expenses (CapEx) of $20,000 during the ownership period, and incurred $6,000 in closing costs when the property was sold. The cost basis would be $330,000, and the capital gains tax liability would be $34,000:

• Cost basis for capital gains tax purposes: $300,000 purchase price + $4,000 capitalized closing costs + $20,000 capital expenses + $6,000 capitalized selling costs = $330,000
• Capital gain: $500,000 sale price – $330,000 cost basis = $170,000
• Capital gains tax = $170,000 x 20% = $34,000

In this revised example, the seller “saved” $6,000 by adjusting the cost basis and would be liable for depreciation recapture tax of $24,000 and capital gains tax of $34,000, for a total tax liability of $58,000.

But what if there was a way to defer paying the entire tax liability when a rental property is sold?

How to avoid depreciation recapture tax

With the proper planning, you can kick your tax liability down the road (and eventually make it disappear) even after you’ve kicked the bucket.

1031 tax-deferred exchange

A 1031 tax-deferred exchange is an IRS code that allows an investor to defer paying capital gains on the sale of investment real estate as long as the proceeds from the sale are reinvested in similar property.

There are a few general rules that an investor must follow in order to defer paying capital gains: 

• The property must be held for investment or business purposes and not for personal use.
• The investor must identify potential replacement properties within 45 days of the sale of the original property and must close on the replacement property within 180 days of the sale of the original property.
• The replacement property must be another piece of investment or business real estate.
• The investor must use a qualified intermediary to facilitate the exchange.

With careful planning, a 1031 exchange can be a valuable tool for real estate investors. By deferring capital gains, investors can reinvest their money in new property and continue to grow their portfolios without paying taxes on their profits.

Estate planning

What happens if you do not want to swap the property but are looking for another option to avoid depreciation recapture tax? That’s where the stepped-up basis comes in.

You can continue holding the property, enjoying annual depreciation expense deductions, and pass the property on to your beneficiaries when you die.

While this can be one way to build generational wealth, it also helps you avoid deferred depreciation recapture tax and capital gains tax entirely. Your heirs will inherit the rental property but not its liabilities, like the deferred tax liability or depreciation recapture tax. Moreover, once the investor dies, the property’s cost basis is stepped up to capture inflation rates and is used as the new cost basis.

Let’s assume the investor in our previous example lived for 2 more years while still holding the property. Two years from now, the property has a market value of $520,000.

When the investor dies, the property’s cost basis will be stepped up to $520,000. So, the heirs will inherit the property worth $520,000 and will have no deferred depreciation recapture tax and capital gains tax to pay.

Better still, if they continue to hold the property as a rental instead of selling, the depreciation clock of 27.5 years is restarted. Then, they can start depreciating it using the new cost basis of $520,000 and an annual depreciation expense of $18,909.09.

Closing thoughts

Depreciation expense can be an excellent tax strategy for reducing your tax burden as a real estate investor. However, it can set you back thousands of dollars in taxes when it is time to sell the property, thanks to depreciation recapture tax. This is because the IRS uses it as a way to reclaim the tax break you enjoyed when you owned the property. 

Fortunately, there are ways to avoid it. You can either use proceeds from the sale to buy a similar property and defer the taxes, or you can pass on the property to your heirs. To accurately track your rental property depreciation, sign up for a free account with Stessa, a Roofstock company. Then, when the time comes to sell, be sure to speak with a qualified tax professional.