What is depreciation recapture?

[Megan Hirlehey]

Hi BP. I keep seeing the term “depreciation recapture” pop up in my research, and it sounds like a b!tch. How exactly does it apply to real estate investing and on what types of real estate deals would you encounter it (flips, buy and hold, wholesale, etc)? I’m just trying to learn more about if it is something I’ll likely encounter in my strategy of mostly “buy and hold” and how to plan for it. Thanks!

[Ian Tvardovskaya]

Basically, at time of sale, you need to add depreciation back into the property's basis. Example: Basis at purchase $39,000. Held for 10 years. Depreciation table is 39 years. Yearly depreciation is $1,000 per year. Sold for $50,000. 

Your basis in the property at the time of sale is: $29,000 ($39,000 - $10,000). Gain is sale is $11,000. ($50,000 - $2,000). 

This gain gets put into a complicated accounting provision called §1231 and comes out as long-term capital gains or an ordinary loss. Problem is you have been taking a $10,000 depreciation against your ordinary income for the last 10 years and IRS won't let you now take the entire gain at a lower tax. 

The result, you must recapture the $10,000 depreciation and it will be taxed as ordinary income. The remaining gain, here $1,000, will go into that complicated §1231 analysis. 

A buy and hold strategy will encounter this the most because they are actively taking depreciation on the property.