Can someone please explain

Question

First, depreciation is a short-term benefit. It puts extra money in your pocket every year while you own the property. But, when a property is sold, previous depreciation deductions taken from the property will have to be repaid to the IRS. Depending on your financial situation, the amount repaid may be the same, more or less than the amount you originally were able to save through the deduction.

I'm not understanding how this is done?

David M. · Answer

@Jimmy Bell

Correct.  Via depreciation unrecapture you generally pay 25% on the depreciation that was taken before.  There is no free lunch with the IRS.

Every year you are required to take depreciation, it is saving you from paying some tax on your rent.  So, perhaps you can say your save a few cents on the dollar if your eff/marginal tax rate is above the 25%.  Don't forget that the losses you can't / don't carry onto your 1040 are carried over year over year as Passive Allowed Losses (PAL).  So, when you sell those losses come flooding in.  So, while its not a direct offset on your return, it can help offset the depreciation unrecapture you have to pay.  So, I agree.. its just money washing back and forth.  Unless you are "playing a big game," saying that depreciation is a wonder drug is really just making lemonade out of lemons.

Remember, if you do a 1031 exchange you can defer the depreciation liablility along with the capital gains liabiity..  So, there are ways to try to handle it.

In larger deals, this is where cost segregation helps as it 'pulls' more of those deduction earlier in your ownership.  So, you depreciate the hell out of your property in some 5-7 years, then 1031 into another property.  Then, do it again...  You can potentially have massive noncash deduction, i.e. the depreciation, thus protecting/sheltering your income from tax.

Does that help answer your question?

Julio Gonzalez · Answer

@Jimmy Bell That's a great question. Depreciation recapture calculations can be a bit confusing, especially once cost segregation comes into play. Here's an article I wrote explaining the deprecation recapture and ways around it. As others have mentioned, you can do a 1031 exchange to defer your capital gains. If at some point down the road, you want to switch your real estate investments from active to passive, you can always do a 721 exchange into a REIT and still defer those capital gains taxes. There's quite a few options, it's just really important to tax strategize ahead of time.

https://www.biggerpockets.com/...

Here's another one too that shows additional benefits of a cost segregation study/accelerated depreciation/bonus depreciation on top of the one you mentioned - extra money in your pocket every year. These help offset the headache of recapture.

https://www.biggerpockets.com/...

David M. · Answer

@Jimmy Bell

bascially up until the part of death and heirs...

Just to "spruce up" your summary:

Yearly you take depreciation which counts as an "expense" to your property.  If your rent was more than the rest of you expenses, now the depreciation deduction means you don't pay taxes on that "surplus" rent...

Yes, when you sell you pay 25% on the total depreciated amount and whatever capital gains tax is due on any appreciation.  If you do a 1031 exchange, then all that tax liability is deferred into/with the next building.

When you die, all the tax liabilities are wiped away with the "step up in basis on death."  So, your heirs get it with no tax liability.  Hence, the phrase "swap 'til you drop" or "1030 until you drop."  Or, the usual "... death and taxes" comes into play...

Alex Olson · Answer

@Jimmy Bell For my simple brain, I let the CPA take care of what I would owe and don't owe. As @David M. indicates a 1031 exchange allows you to DEFER ALL capital gains tax when you sell by exchanging into a different asset. This is why you see a lot of people who have either obtained serious equity through appreciation or have owned for a long time and their depreciation recapture would be huge - they complete a 1031 exchange to utilize their untapped equity and protect their tax consequences. Happy to discuss this further.

Chris McCormack · Answer

Understand there are many tax planning opportunities that can mitigate recapture and deferment. Make sure you get tax planning with your CPA

Jimmy Bell · Answer

Thx david I got it!!

Jimmy Bell · Answer

So basically they defer your tax liability while you depreciate your building, so you don't pay as much tax. Then in the end once you sell the building they come back and make you pay in taxes, 25% of what you depreciated unless you 1031 to a building that is similar. but then if you 1031 exchange it the burden does not go away it just gets moved to the next property and builds from property to property. When you die then your heirs will have the burden to pay. if they cant pay then they take the building to pay your taxes!! Is that correct.

David M. · Answer

@Jimmy Bell

Oh, should mention the notion that you "1031 until you die..."  Because once you start down that road, usually its hard to get out of because your tax liability will become very high because of all the deferments.  Meanwhile, you can only really exchange "up."  Other than dieing in which case your heirs receive the property with the autmoatic step up in basis, its extremely difficult to get out it.  Good luck.

Jimmy Bell · Answer

I'm so greatful to you guys for taking the time to answer my question. Just trying to understand what I'm getting myself into in the near future. Thank you all so much

Steve Vaughan · Answer

Yeah, I wish it wasn't required.  We had no other income the first 7 years we went full time and absolutely didn't need it.

Being forced to take all allowed or allowable is BS.

Can someone please explain

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