Depreciation recapture ... really?

[Anna Smith]

We became accidental landlords ten years ago. It has been a terrible investment. We are thinking of selling it and am embarrassed to admit I didn't know about depreciation recapture till recently. WTH? We would now like to become intentional landlords. I know I can do a 1031 exchange, but am not sure if I am up to it right now. Did everyone know about this but us? It changes my perspective on investing in real estate. Please someone tell me why this is a law?

[Paul Caputo]

Why is depreciation and recapture tax law? Because it doesn't make sense to be able to expense real property. Purchasing real property will probably be one of the largest expenses for any business, but since real property has a long useful life that is over a year you can't expense the whole amount in the first year. Instead you have to depreciate it over its useful life which effectively gives you a partial expense deduction each year on the real property. With normal business expenses those costs are usually sunk immediately and you can't recoup those costs. With real property you can recoup some or all of your costs by selling. So it makes sense that when you sell the property you are no longer entitled to the deductions associated with purchasing the property. That's where depreciation recapture comes in and the government takes back those deductions, generally at a better rate for you than when you took it: recapture is taxed at 25%, while depreciation deductions will be applied at your top marginal tax rate which is usually at least 25% and currently can go up to 39.6%. So ideally the actual tax benefits from depreciation outweigh recapture by about 35% at current tax rates. Recapture is only on allowable depreciation, any gains above that are capital gains taxed at 15%.

Does that make sense? It definitely is a raw deal if you didn't know about it and weren't taking it, but there's some good news too.

The IRS doesn't care if you claimed it or not they're gonna hit you with recapture either way upon sale. The nice thing is they let you catch up on it if you haven't taken depreciation or calculated incorrectly.

It's called a section 481(a) adjustment and you get it by filing IRS Form 3115 with the proper documentation. The best way to do that is a cost segregation study on the property. This will correct your depreciation according to MACRS and bring you into full compliance with the tax code as long as it's done right. I'd be happy to help anyone who wants to correct their depreciation with a cost segregation study since I'm a cost segregation specialist.

Beyond that you can do a 1031 exchange and avoid recapture at the moment, but if you later sell that new property from the 1031 exchange without another 1031 exchange you'll pay recapture. So if you're gonna go that route you usually 1031 until you die. But the reason you don't pay recapture is your cost basis transfers to the new property and you continue depreciation on the new property as if it were the old property. So it comes down to what makes more sense with the specific properties. If you're trading up in value considerably combining a 1031 exchange with a cost segregation study will allow you to maximize tax deferral on the property. A Qualified Intermediary would be able to help you with 1031 exchanges, but you'll probably need a commercial real estate agent and a CPA involved too to get all that figured out and into the new property.

Hope this helps and better luck on your next property!