Recapture Of Depreciation On Sale Of Real Estate
When you sell real estate, you may be required to recapture all or a portion of the depreciation you claimed while you owned the property. This is known as the recapture of depreciation on sale of real estate. Recapture occurs when the depreciation deductions you claimed on your tax returns exceeded the actual depreciation that occurred on the property.
How Depreciation Works
Depreciation is a tax deduction that allows you to write off the cost of the property over a period of time, typically 27.5 years for residential rental property and 39 years for commercial property. You can deduct a portion of the property's value each year as a depreciation expense on your tax return. This reduces your taxable income and lowers your tax liability.
For example, if you own a rental property with a cost basis of $200,000, you can deduct $7,273 ($200,000/27.5) each year as a depreciation expense.
Recapture of Depreciation
When you sell a property that you have claimed depreciation on, the IRS requires you to recapture some or all of the depreciation you claimed. This means that you must add back the depreciation deductions you claimed to your taxable income in the year of the sale.
The recapture amount is the difference between the depreciation deductions you claimed and the actual depreciation that occurred on the property. For example, if you claimed $50,000 in depreciation on a property but the actual depreciation was only $40,000, you would have to recapture $10,000 in depreciation when you sell the property.
Calculating Recapture
The recapture amount is calculated by subtracting the property's adjusted basis from its selling price. The adjusted basis is the original cost of the property plus any capital improvements you made, minus any depreciation you claimed.
For example, if you purchased a property for $200,000 and claimed $50,000 in depreciation, and you sold it for $300,000, your adjusted basis would be $150,000 ($200,000 - $50,000). Your recapture amount would be $100,000 ($300,000 - $150,000).
Capital Gains Tax
When you sell a property, you may also be subject to capital gains tax on the profit you make from the sale. The capital gains tax rate depends on how long you owned the property and your income level.
If you held the property for more than a year, you will be subject to long-term capital gains tax rates, which are generally lower than short-term rates. The maximum long-term capital gains tax rate is currently 20% for high-income taxpayers.
Avoiding Recapture
There are several ways to avoid or minimize recapture of depreciation on the sale of real estate. One way is to make a tax-deferred exchange under Section 1031 of the Internal Revenue Code. This allows you to exchange one property for another of equal or greater value without recognizing any gain or loss on the sale.
Another way to avoid recapture is to convert the property to your primary residence before you sell it. If you live in the property for at least two years before you sell it, you may be able to exclude up to $250,000 ($500,000 for married couples filing jointly) of the gain from your taxable income.
Conclusion
The recapture of depreciation on the sale of real estate can be a significant tax liability for property owners. It is important to understand how depreciation works and how it can affect your tax liability when you sell your property. Consult with a tax professional to determine the best strategy for minimizing your tax liability and maximizing your profits.