Understanding Rental Property Depreciation and Recapture Tax

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

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

Since depreciation allowance is one of the tax shelter benefits associated with real estate investing that enables investors to perhaps enjoy positive cash flow by writing off the property's allowable IRS tax depreciation and recapture tax can perhaps result in an unexpected IRS expense at the time of selling the property, it seemed needful to explain how it all works.

Depreciation

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.

For 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 would apply to non-residential, or commercial property) and therefore would allow the real estate investor to take an annual depreciation allowance deduction (other than the purchase and sale years) as follows:

$400,000 / 27.5 = $14,544

The purchase and sale years would typically apply the "mid-month convention" and slightly reduce the amount of depreciation allowance for those initial and final years, but is purposely ignored in this illustration.

Recapture Tax

In effect, because the depreciation taken 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 of 25% (per the Taxpayer Relief Act of 1997).

For 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 true benefits of real estate investing that 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.