Depreciation

When a property is owned and used for business or investment purposes, the Internal Revenue Service (IRS) allows the owner to claim depreciation deductions on their tax return.

These deductions are designed to reflect the property's wear and tear and obsolescence over time, and can significantly reduce the owner's tax liability.

For example, residential rental property is generally depreciated over a 27.5-year period, while commercial property is depreciated over a 39-year period. The property's basis, or cost, is divided by the number of years in the depreciation period to determine the annual depreciation deduction.

Depreciation recapture

However, when the property is sold for a profit, the IRS requires the owner to "recapture" the depreciation that was previously claimed. This means that the owner must pay taxes on the portion of the sale price that represents the depreciation that was taken. The tax rate for depreciation recapture is currently capped at 25%.

Example:

Let's say that John owns a rental property that he purchased for $200,000. Over the years, John has claimed $50,000 in depreciation deductions on his tax returns. Now, John has decided to sell the property for $300,000.

Since John claimed depreciation deductions on his tax returns, he will be required to pay taxes on the portion of the sale price that represents the depreciation that was taken. In this case, the property was sold for $300,000 and John claimed $50,000 in depreciation.

At a tax rate of 25%, John will owe $50,000 x 25% = $12,500 in taxes on the depreciation recapture.

So, in this example, John will need to pay a total of $12,500 in taxes on the depreciation recapture, plus any additional capital gains tax that he owes on the sale of the property.

Ways to avoid or minimize depreciation recapture

1.    Use the property as your primary residence: If the property is used as your primary residence and meets certain criteria, you may be eligible for the capital gains exclusion, which allows you to exclude a portion of the sale price from taxation. To qualify for the capital gains exclusion, you must have owned and lived in the property for at least two of the past five years.

2.    Exchange the property for another investment: If you exchange the property for another investment, such as another rental property, through a 1031 exchange, you may be able to defer the payment of taxes on the sale. A 1031 exchange allows you to postpone paying taxes on the sale of a property as long as the proceeds from the sale are reinvested in a similar property.

3.    Invest in another property and use the depreciation (passive losses) from that property to offset both depreciation recapture and capital gains of this property. This can be done by investing in a real estate syndication that does cost segregation analysis and bonus depreciation.

4.    Use the property for charitable purposes: If you donate the property to a charitable organization, you may be able to claim a charitable deduction on your tax return, which can offset the tax liability from the sale of the property.

5.    Sell the property to a related party: If you sell the property to a related party, such as a spouse or a family member, the rules for depreciation recapture may not apply.

Always consult a qualified CPA or tax professional for your particular situation.