While you can claim many expenses as write offs in the year you make them, the IRS treats buying a rental property not as an expense but as a conversion — In other words, you’re turning cash into an asset with value, meaning that no net change to your personal wealth has occurred. However, since buildings gradually wear out, the IRS lets you depreciate it by taking a small portion of value as an expense every year, writing down its value and reducing your taxes. With something like a computer or a car that usually ends up being worthless at the end of its “useful life,” this is not a problem. Real estate, though, usually goes up in value. So what do you do when you depreciate a rental property?
Since you get to write off an expense without actually spending money, depreciation should be a benefit to you for as long as you own the property and it still has value to depreciate. You don’t need to worry about paying it back until you sell the property. That’s when you actually experience a taxable event and can incur a gain.
When You Have to Pay Back Depreciation
Because depreciation is an accounting tool that lets you adjust value for “using up” the value of your asset, the IRS expects that you will sell it for less than the depreciated value. If you sell your asset for more that its depreciated value, the IRS requires you to pay it tax on that gain. This tax is called “Depreciation Recapture Tax” and is also referred to as Section 1250 recapture.
How Depreciation Recapture Tax Works
The tax rate on recaptured deprecation is 25 percent. The best way to understand how it works is through an example. Consider a rental property that you bought 15 years ago for $250,000 and just sold for $350,000. Your analysis showed that $180,000 of the value was in the depreciable buillding and $70,000 was in non-depreciable land. You would have a $100,000 capital gain on the difference between the original purchase price and the selling price, taxable at 15 percent in the 2012 tax year. In addition, the $6,545 per year depreciation that you claimed based on the asset’s 27.5 year life, which adds up to $98,175, is taxable at 25 percent as recapture. This leads to a total tax bill on the sale of $39,544, based on $15,000 in gains tax and $24,544 in recapture tax.
Avoiding Depreciation Recapture Tax
You can’t avoid the recapture tax by not claiming depreciation. The IRS calculates recapture on the depreciation that you were legally allowed to claim whether or not you actually claimed it. The best way to get out of paying recapture is to use the proceeds from the sale of your rental property to buy another piece of investment property that is the same size or larger. Structuring your transaction as a 1031 exchange and following the IRS’s rules for that process lets you carry your proceeds, and your tax basis, forward into a new property without paying depreciation recapture or capital gains taxes.
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