Recovery of rental property depreciation refers to a provision for capital gains taxes due to depreciation commonly faced by real estate investors selling their rental property.
In essence, depreciation recovery is the way in which the Internal Revenue Service can “recover” taxes on all or part of the gain on the disposal of the asset as ordinary income, rather than solely as capital gain ( which is often at a lower rate).
The arrangement is far from simple. In fact, determining the amount subject to recovery is typically characterized as one of the most confusing income tax obligations faced by real estate investors selling rental properties. Mainly because the specific rules are detailed and subject to change.
Therefore, the following article is intended to help you understand the general concept of recovery for depreciation only. Investors should always consult with qualified legal and tax advisers when making real estate investment decisions.
Okay, let’s go through the process starting at the beginning.
The allowance for depreciation (or “cost recovery”) is one of the biggest tax deduction advantages the IRS gives owners of rental properties during the life of their property.
Under the current Internal Revenue Code, from the time the real property is put into service until the time title is transferred or reaches the depreciation limit set by the IRS, investors can deduct an amount for the cost recovery each year on physical structures (called “improvements”) as an income tax deduction.
The amount of that annual deduction is determined by the “useful life” of the asset as specified in the code. Currently the useful life of residential rental properties (buildings occupied by tenants as housing) is 27.5 years and of non-residential rental properties (buildings occupied for commercial purposes) 39 years.
For example, let’s say you buy an apartment complex for $ 800,000, of which 70 percent is attributable to physical improvements. According to the IRS, you would have a “depreciable basis” of $ 560,000 (800,000 x.70) that you can depreciate over its useful life. Thus, dividing that depreciable base by the useful life (560,000 / 27.5), you establish that you can claim a deduction for cost recovery to offset your taxable income each year in the amount of $ 20,364.
Note that both the year of purchase and the year of sale would calculate a slightly different amount due to the “mid-month convention” provided by the tax code. In the real world, of course, this convention would be considered, but for our purposes the convention is ignored just to keep it simple.
Fair enough. So let’s continue to show you why the feds stepped in with depreciation recovery and IRS Code Section 1250 was created.
Since the taxpayer made a profit by offsetting ordinary income by owning a depreciable rental property, the IRS concludes that the taxpayer must repay him that profit when the property is sold.
Let’s consider an example to give you the idea. Suppose you sell your real estate investment after five years for $ 900,000. This is how the Internal Revenue Service determines your profit on the sale.
1. First, the total amount of deductions claimed during the withholding period is calculated by taking your annual depreciation deductions for the number of years claimed (20,364 x 5), or $ 101,820.
2. Second, your property’s “adjusted basis” is calculated by reducing your original basis (purchase price) by the amount of deductions you claimed (800,000 – 101,820), or $ 698,180.
3. Finally, your “profit” is calculated by deducting the property’s adjusted basis from its sale price (900,000 – 698,180), or $ 201,820.
It is worth noting how the IRS benefits from this method. For example, if your profit on the sale was simply calculated as the sales price minus your original basis (900,000 – 800,000), your profit would be $ 100,000. In this case, however, your profit increases to $ 201,820, which means the IRS can tax you on an additional $ 101,820.
Okay, now let’s consider how taxes are collected.
Since capital gains income tax is often less than ordinary income taxes, rather than simply taxing the investor’s full amount at the capital gains rate, the IRS applies depreciation recovery. This allows them to take the total depreciation deductions claimed by the investor back into income and tax them as ordinary income.
Is that how it works.
Depreciation deductions of $ 101,820 taken by the real estate investor are taxed at the recovery cost recovery tax rate, and the remaining $ 100,000 (201,820 – 101,820) is taxed at the capital gains rate.
For example, if the recovery tax rate is 25% (the maximum allowed) and the capital gains tax rate is (say) 20%, then due to the sale, the taxpayer owes the federal $ 25,455 (101,820 x.25) plus $ 20,000 (100,000 x 20) or $ 45,455.
Of course, this depreciation recovery tax method can cause a significant tax impact for real estate investors selling rental properties. Consider this in conjunction with the illustrations above to see what I mean.
Without any consideration for deductions for depreciation, the investor’s tax liability at the time of sale would simply be calculated as the sale price less the purchase price (900,000 – 800,000), or $ 100,000 taxed at the capital gains rate. (100,000 x 20), or $ 20,000.
Considering that, with this consideration, the investor’s obligation to the IRS is based on an increase in profit caused by deductions for depreciation and then partially taxed as ordinary income and capital gains, which, as we illustrate, results in an obligation tax of $ 45,455. In other words, the real estate investor’s obligation to internal income by this method increases by $ 25,455.
Okay, but even if we assume the highest adjusted profit of $ 201,820, we can still see how the recovery from depreciation impacts the investor. Without it, the investor’s obligation to the IRS would be based on the total amount taxed solely at the capital gains rate (201,820 x.20), resulting in a tax liability of $ 40,364. However, if partially taxed as recovery and the remainder as capital gains, the obligation becomes $ 45,455 (an increase of $ 5,091).
Just one more thought and we’re done.
Several conditions must be met at the time of a rental property sale for depreciation recovery tax to be charged. The tax event takes place only at the time the asset is disposed of. Second, depreciable real estate must be sold after one year of ownership; otherwise, they are considered short-term capital gains and no payback is applied. Third, the investor must demonstrate a gain recognized as a result of the sale (there is no recovery when the taxpayer takes a loss). Fourth, the amount subject to recovery cannot exceed the gain made and cannot exceed a tax rate of 25 percent.
For the success of your real estate investment.