Depreciation Recapture Tax: Do You Know What the IRS Collects When You Sell Your Rental Income Property?

One of the financial benefits real estate investors enjoy by real estate investing is the allowable IRS deduction they can make for depreciation (or cost recovery) by owning rental property.

This is particularly of great benefit to those engaged in real estate investing because it represents a “paper write-off” for investors during each of the years that the investor owns the rental property.

In other words, depreciation is not an actual out-of-pocket expense the investor must shell out money but rather a "deduction" allowable by the IRS the real estate investor can write off until the entire rental property is depreciated and the asset written off.

Here’s how it works.

Depreciation Allowance

The IRS permits investment real estate owners to write off the physical improvements each year according to the asset’s useful life as specified in the current IRS tax code.

  • 27.5 Years This is applied to residential property (i.e., tenants occupy the property as housing)
  • 39 Years This is applied to "nonresidential property" (i.e., office complexes, retail centers, industrial centers, etc.)

Formulation

Depreciation Allowance (annually) = Depreciable Basis / Useful Life

Example

If an apartment rental property is valued at $800,000 of which 70% is attributed to physical improvements (according to local tax records), then the depreciable basis for the property is $560,000 ($800,000 times 70%).

Since the useful life attributed to the property by the IRS is 27.5 years for residential property, the real estate investor is entitled to write off as an annual depreciation allowance (i.e., an annual tax deduction) the amount of $20,364 ($560,000 / 27.5).

Okay, but here’s the rub.

Depreciation Recapture Tax

When the real estate investor sells the rental income property, he or she will obligated to pay the IRS a tax on the amount of accumulated depreciation taken during the years of ownership.

This is what is known as the “depreciation recapture tax” (currently 25%).

Here’s how it works.

Example

Say that the investor sells the apartment complex after ten years of ownership during which time he or she has written off an accumulated total of $203,640 as depreciation allowance. In this case, the investor would owe the IRS an amount of $50,910 as a result of the sale ($203,640 times 25%0.

Conditions

There are several conditions for this recapture tax to be levied, however.

  • The depreciable real estate is sold after one year of ownership
  • The real estate investor shows a recognized gain as a result of the sale
  • The amount subject to depreciation recapture cannot exceed the gain realized

In other words, if the investor disposes of the rental property during the first twelve months of ownership or disposes of it at a loss, then the recapture of depreciation rules don’t apply.

Rule of Thumb

Become familiar enough with the depreciation recapture tax to know that it might apply when you sell a rental property because it has been a surprise to some real estate investors at tax time. But always consult a tax specialist before you sell rental property. If you have a sound tax strategy beforehand you avoid letting the recapture tax catch you off guard at tax time.

About the Author

James Kobzeff is a real estate professional and the owner/developer of ProAPOD - leading real estate investing software solutions since 2000. Create cash flow, rates of return, and profitability analysis on rental property at your fingertips in minutes where recapture tax is automatically calculated.

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