The Depreciation Recapture Tax You May Owe When You Sell Rental Property

jim kobzeff

by James Kobzeff
Nov 21, 2018

A few years ago when I was still actively selling investment real estate, one of my customers recounted a story about the first time he learned about the depreciation recapture tax, and it wasn't a pleasant experience.

He had just sold an income property he had owned for several years, but instead of collecting the amount he had estimated would be his cash proceeds, he was surprised to discover that he owed the IRS a "recapture tax", and subsequently wound up collecting less cash proceeds from his sale than expected.

Since it's likely other real estate investors might not know about this depreciation recapture tax, it seemed needful to discuss it.

But not so much in technical terms (there are highly informative articles on the subject elsewhere on the web). My aim is merely to make you aware of the depreciation recapture tax in hopes that you will seek tax counsel so the IRS doesn't catch you by surprise with this tax once you've sold your income-producing property.

What is Depreciation Recapture?

Depreciation recapture is an Internal Revenue Service (IRS) procedure for collecting income tax from a real estate investor when he or she disposes of an asset that had been providing an offset to ordinary income through depreciation; and when justifiable, the result is this depreciation recapture tax.

Here's the idea.

The Feds feel that any gain a real estate investor realizes when an investment gets sold is in part due to the depreciation allowance they've enjoyed during ownership, which in turn meant less revenue for the IRS. Now they expect the investor to pay for that accumulated depreciation allowance in order for them to "recover" that revenue by using depreciation recapture to tax the gain.

In other words, because the taxpayer received a deduction from ordinary income for the depreciation of the asset, any gain the taxpayer receives up to the depreciation amount must be included as ordinary income to offset the earlier deduction and then is taxed at the recapture tax rate.

Okay. Now let me show you how the effect of that reckoning can cause a higher tax liability for the investor at the closing of a sale than by applying the capital gain taxes alone.

Example:

Say you own a commercial real estate building and have deducted $100,000 of depreciation following years o ownership, and that depreciation reduces your basis in the property and thus results in a $300,000 taxable (long-term) gain when you sell. Moreover, we'll assume that the first $100,000 (the un-recaptured Section 1250 gain) is taxed at a maximum federal rate of 25%, and based upon your tax bracket, that the remaining $200,000 gain gets taxed at 20%.

Okay, let's look at the impact depreciation recapture makes.

  1. Capital gains tax alone. Here the investor's tax liability would be $300,000 x 20%, or $60,000.
  2. With depreciation recapture. Here the first $100,000 is taxed at 25%, and only $200,000 gets taxed at 20%. That is, (100,000 x .25 = 25,000) + (200,000 x .20 = 40,000), or $65,000.

In other words, the real estate investor will owe the Feds $5,000 more in taxes (65,000 - 60,000) by virtue of the recapture tax than not. And you can see how that would displease any real estate investor that sells a rental property and wasn't expecting it.

General Guidelines

Recapture tax occurs when the depreciable real estate gets sold after one year of ownership at a gain. Property sold one year or less would be classified as a "short-term" and gets taxed as ordinary income. Property sold at a loss can be deducted on your tax return and used to reduce other income.

Rule of thumb.

I intend this article only to give you a general idea of the depreciation recapture method. It is not tax advice. Real estate investing requires sound real estate investment tax strategies and good planning. It is strongly recommended that you always consult a tax specialist before you sell any investment real estate property.

So You Know

ProAPOD Executive 10 real estate investing software calculates the depreciation recapture tax when arriving at sales proceeds after taxes.

Here's to your real estate investing success.

james kobzeff author

James Kobzeff is a former realtor with over thirty years of investment property experience and is the owner/developer of ProAPOD Real Estate Software.