Depreciation Allowance and Recapture Tax

jim kobzeff


Feb 25, 2016

Depreciation allowance and recapture tax are two sides of a "proverbial coin" associated with the IRS income tax shelter elements that directly affect investors who own real estate income property.

Whereas the tax code permits real estate investors an annual depreciation allowance for real estate investment property ownership, on the flip side it also expects repayment of that allowance when the investor sells the rental income property.

Here's how it works.

Depreciation Allowance

The tax code assumes that the investment property buildings (not the land) are wearing out over time and therefore becoming less valuable. As a result, the IRS permits income property owners to get a deduction as "cost recovery" for that presumed "paper loss" decline in property value.

Example

Let's assume that you purchase a multifamily income property for $500,000 of which $400,000 is attributable to the buildings. Since this is residential property the IRS would assume a useful life of 27.5 years (39 years for commercial property) and therefore would allow the real estate investor to take an annual depreciation allowance deduction as follows:

$400,000 / 27.5 = $14,544

Note The example above reflects the "annual" depreciation allowance (i.e., a full twelve months). The purchase and sale years would typically apply the "mid-month convention" and therefore only applies one-half the allowance for the month in which the purchase or sale is made.

Recapture Tax

Because the depreciation allowance deducted from our income taxes during ownership reduces our investment property's tax basis and effectively increases our tax gain when we later sell, the IRS assumes that our gain in part may have resulted from the depreciation we took during ownership. Therefore it imposes a tax to "recapture" those gains attributable to depreciation taken during our ownership. The recapture tax is currently 25% per the Taxpayer Relief Act of 1997.

Example

Let's assume that you sell your multifamily property at a gain greater than your accumulated tax depreciation (which we'll say is $144,232 and your gain is greater). Since your gain is greater than your tax depreciation, the recapture rule will apply. As a result, your tax on sale will include the recapture tax of $36,508 ($144,232 x .25) plus a capital gains tax on the adjusted net capital gain.

Bottom Line

The depreciation allowance allowed by the IRS is one of the benefits of real estate investing that really can profit investors. Just bear in mind that the IRS also imposes a recapture tax to get some of those benefits back when you sell the property.

So You Know

ProAPOD's Executive 10 real estate investing software automatically computes depreciation and recapture tax. You simply fill in the forms. ProAPOD applies the correct depreciation schedule and makes all the necessary calculations.

james kobzeff author

James Kobzeff
Jim is a former realtor with over thirty years real estate investment property experience. He is the developer of ProAPOD's investment real estate analysis software solutions.