Real estate is a popular investment vehicle among those with disposable funds, and for good reason: though not without its risks, real estate can provide investors with steady rents or large sums from sales. The economic downturn of the late 2000s shook the confidence many investors previously placed in the real estate market, but most market research studies show encouraging signs of recovery in the last few years. No matter how quick or slow the recovery proceeds, the intrinsic value of real estate will always attract a certain number of investors who are hungry to grow their wealth.
Many real estate investors are unaware of the range of taxes that they may be subject to if they decide to cash out of their investment in a straight sale. Along with capital gain taxation, investors will also be subject to something called depreciation recapture. In this article, we will discuss the essential points of depreciation recapture taxation and how this type of tax is calculated. As you will see, depreciation recapture currently stands as the single largest source of taxation when an investor sells their investment real estate.
Basics of Depreciation Recapture
Depreciation is a foundational concept in finance. All professionals who deal with finance on some level must be conversant with this idea. This is true regardless of whether they be a New York tax attorney, Wall Street bond broker or Silicon Valley hedge fund manager. When someone purchases an investment property, whether real or personal, that property is considered to have a “useful life.” This means that the value of the property – expressed in its basis – declines gradually over a fixed period of time. Each year, investors take a “depreciation deduction” which represents the amount by which the property has declined in value. The investor’s basis is reduced by the deduction, and then the investor will factor in this adjusted basis in the case of an eventual sale. These depreciation deductions are intended to offset the reduced value of the asset for the investor.
The (current) useful life for investment rental real estate is 27.5 years, while the useful life for retail and other pieces of investment commercial real estate is 39 years. If an investor purchases a rental property for $500,000 and holds on to the property for the entire duration of its useful life, the adjusted basis in the property will drop to zero, unless the investor makes any capital improvements. When the investor takes depreciation deductions over time, these deductions are considered a form of gain, and the taxation of this gain is referred to as “depreciation recapture.”
The current tax rate for depreciation recapture is 25%. The methodology for calculating depreciation recapture is relatively straightforward: depreciation is taxed separately from other forms of taxation – i.e. capital gains, state income tax, medicare surtax – and is taxed at both the state and federal levels. The taxation of depreciation recapture is a compelling enough reason on its own to justify a Section 1031 tax-deferred exchange.
Let’s look at one scenario to illustrate the calculation methodology for depreciation recapture. Suppose an investor buys a new rental property for $750,000. Under the current depreciation schedule, this means that the investor will take an annual depreciation deduction of $27,273 (rounded up from $27,272.72, because that is the quotient of $750,000 divided by 27.5). Let’s further suppose that our investor holds the property for 10 years before disposing of the property in a straight sale. After 10 years, the property will have an adjusted basis of $477,273, as the investor will have taken a total of $272,727 in depreciation deductions. No matter what the final sales price of the rental property, the investor will be taxed on this “gain” of $272,727 in combined depreciation deductions, and so he will face a liability of approximately $68,182 (this is the product of $272,727 multiplied by 25%). If the rental property is located in a state with state income tax, then the investor will also pay tax on the gain associated with this depreciation at the state level, although the gain will be taxed at the state income tax rate rather than the federal depreciation recapture tax rate.
As mentioned, depreciation recapture is an essential concept in real estate taxation. Our tax law has been crafted so that investors receive the benefits of depreciation deductions, but the tradeoff is that they face potentially stiff liabilities stemming from depreciation recapture following a sale. Investors should factor in depreciation recapture when contemplating a sale and plan ahead for the liability which will result if they decide not to perform a 1031 exchange.
About the Author: Jorgen Rex Olson is a graduate of Washington State (B.A., cum laude, 2008) and the Indiana University (McKinney) School of Law (J.D., 2012). He writes for Mackay, Caswell & Callahan, P.C., one of the leading tax law firms in New York State.