Understanding Depreciation Recapture & Real Cost of Selling

Here at JB2, we use depreciation creatively to offset a lot of the income we are making on the buildings. We also utilize bonus depreciation to take advantage of the depreciation further. Part of the reason our goal is not to sell but hold very long term is to avoid depreciation recapture.

What is Depreciation?

One of real estate's most significant tax benefits is that the IRS allows you to depreciate rental property, not the land value, for each year of ownership up to 27.5 years. This paper depreciation expense can offset taxable rental income from the property.

For example, let's say you buy property for $120,000. Let's say the property value is $100,000 ($20,000 for the land); divide that by 27.5 years, and you get $3,636. After all your expenses, your net operating income is $3,636 for the year. 

So, that depreciation expense would offset that rental income, and you would owe no tax. It's tax-free or deferred tax-free income since the IRS will take that back later at the sale, recapturing the depreciation.

Bonus Depreciation

The IRS instituted bonus Depreciation in September of 2017, allowing you to depreciate 20-40% of the depreciable value in the first year. This means you will usually have more losses in the first year to offset other income or carry forward to other years. In our Tax Stack Strategy e-book, we dig into this concept further. This is important because using more depreciation in the front end will significantly increase your recapture tax at a sale. 

What is Depreciation recapture?

Depreciation recapture is the process that occurs when a rental property has been sold. The IRS uses this to collect taxes on your gain from income from selling properties. It also recoups any benefits you receive by using depreciation expense to reduce taxable income. Essentially, they are taking back the benefit they previously gave you. So, while you lower your taxable income year after year, you also reduce your original cost basis equally.

If we take the example from the above, your original tax basis was $100,000, minus, let's say, after five years of ownership (3,626 X 5)- $18,130 = $81,870 is the new cost basis. Suppose you sell it for double in five years at $200,000. So, take the sale price of $200,000 - $81,870 adjusted cost basis, which equals $118,130, the recognized gain. This is how the IRS recaptures your previous depreciation expense. 

The other caveat is the $18,130 recaptured depreciation is taxed as ordinary income. So, in this example, you multiply the depreciation expense of $18,130 X 24% (2021 tax rate for married making between $172,751 to $329,850) equals $4,351 taxes owed. Then, multiply the remaining $100,000 gain by the long-term gain tax rate of 15%, which equals $15,000. So, the total taxes owed on this example sale is $19,351. This article and video go into some more detail here. At the sale, depreciation ultimately gets recaptured, but if a sale needs to happen, you still defer taxes for whatever years you hold the property.

1031

"Thanks to IRC Section 1031, a properly structured 1031 exchange allows an investor to sell a property, to reinvest the proceeds in a new property, and to defer all capital gain taxes." -API exchange.

This is proof that not selling or performing a 1031 is a sound financial decision. By not selling or performing 1031, we avoid paying all the tax burden and depreciation expense. Here at JB2 Investments, we aim to do a refinance instead of sell in hopes that those tax-free refi proceeds are similar to what you would have after the gain from a sale minus the tax burden.

There may be a rare occasion when it does make sense to sell outright. If, for example, we get an incredible price to sell or the property has not been performing, perhaps it doesn't make sense to buy right away because of market conditions. Hopefully, we have enough carried losses from other properties to offset any of these potential gains anyway. Hopefully, what we made abundantly clear here is the actual consequence of selling and why holding longer-term usually makes a lot of sense.