Depreciation Recapture

By Matt Picheny

Depreciation is often touted as an amazing tax benefit available to investors in Real Estate. But no one ever talks about Depreciation Recapture. Perhaps that’s because it’s nuanced and not particularly intuitive, but that’s all the more reason for me to give it some airtime.

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I remember how shocked I was when I saw the taxes I had to pay on the sale of one of my properties! There had been quite a significant amount of depreciation on that property over the years. I had no idea I would have to recapture most of what had been categorized as losses in previous years.

Why even bother with depreciation if you’re just going to get hit with a huge tax bill when you sell? Looking at the bigger picture provides some perspective on depreciation and how this could actually work in your favor.

First, A Quick Reminder

I want to be clear that I’m not a tax advisor! I’m just sharing here what I’ve learned about the importance of understanding how the recapture of depreciation works and how deprecation can still be of benefit to real estate investors.

There are important nuances in how all of this may apply to your own personal circumstances, so before you rush off and make any big decisions, please speak to a tax advisor. I can’t stress enough how important it is to have a trusted tax professional on your team.

What Is Depreciation Recapture?

First, let’s make sure we understand that depreciation is the reduction in the value of a property over time due to wear and tear on the asset. For more about that, check out the post I’ve written about how depreciation works and its benefits.

As I discussed in that post, there isn’t a single rate of depreciation, as there are different types of property and contents within them, and each of these components of the whole will be treated as having its own useful life. This is what a cost segregation study is for — it’s the report conducted by a qualified engineer to identify the components of a property and catalog them into their relevant depreciation classes.

Each asset depreciates over time, so we think of its depreciable basis as the cost of acquisition of that asset (the purchase price) plus the cost incurred to put the asset into service.

The value of the yearly depreciation is categorized as a loss for tax purposes since the items you are depreciating are becoming worth less due to the wear and tear on them.

However, when you sell the property, you must recapture that depreciation. This is recorded as a gain now on your taxes and is subject to specific tax treatment.

In a nutshell, if you sell something (for example, stock in a company) for more than you paid for it, you pay tax on the difference, which is your gain. When you use depreciation, the deductions you take decrease your basis (what you paid) in the asset. When you sell it, since your basis has been lowered from the depreciation, your gains are higher.

Partial Asset Disposition

Things get even more interesting when we look at partial asset disposition.

When you eventually sell the property, you will need to recapture the depreciation taken on any item that remains in use at the property. But what if you’ve made upgrades to the property and replaced some items? 

Partial asset disposition is the removal of the remaining cost of a particular portion of the property that is taken out of service. The remaining cost of the disposed of item(s) produces a tax loss because that portion of the cost had not been deducted yet through depreciation. 

The interesting implication here is that replacing some items at the property while you own it could mean that you don’t need to recapture the depreciation on it — and that could mean future tax savings.

Taking advantage of this sounds exciting but coming up with general rules on how to do it isn’t easy. (That’s why I say it’s a nuanced subject and why getting advice from a tax professional is essential.)

Still, you’re reading this blog for a reason, so let me share some basics related to the three types of tax that are relevant to this discussion.

Tax Brackets

Now let’s go over some basics related to the three types of taxes that are relevant to this discussion. As you surely know, the IRS determines taxes owed based on yearly income. The amount of taxes we owe is a percentage of this income, but the way we earn this income affects the percentage of the tax. Depreciation Recapture has its own rules, as do Capital Gains, as well as Ordinary Income. Let’s look at all three.

Ordinary Income Tax

In 2022, personal tax rates for single filers can be as high as 37%, but here are a couple of common thresholds:

When you earn above $41,776, the personal tax rate is 22%.

When you earn above $170,051, the personal tax rate is 32%.

Capital Gains Tax

Long-term capital gains tax is 15%.

“Long-term” is the key point here. This means that investments have to be held for at least 1 year. Anything less than that means you’re taxed as ordinary income (personal tax rates).

Long-term capital gains tax is 20% if you make over $459,750.

Depreciation Recapture Tax

Depreciation recapture tax is generally the same as your Ordinary Income Tax, except it is capped at 25%.

Three Scenarios

I’m at pains to repeat that coming up with general rules is tough. However, since interpreting the impact of the information above can be a bit difficult, here are three scenarios that exemplify how these different taxes could play out depending on your income.

I’m basing this all off of 2022 tax rates.

Scenario #1

If you earn between $41,776 and $170,051, you could pay less tax from gains in a long-term investment in real estate than you do from regular earnings. Again, this assumes you own the property for at least 1 year.

In this case, you would pay only 15% on your capital gains instead of the normal 22% to 24% on ordinary income for single filers.

But don’t forget, for any depreciation you had while you owned the property, you would need to recapture it. That recapture is taxed at a maximum of your ordinary income rate, depending on some variables (there’s that nuance again), though it could be less.

Scenario #2

If your ordinary income goes above $170,051, your capital gains of 15% and depreciation recapture cap of 25% are both lower than your 32% tax bracket for ordinary income.

Scenario #3

If your ordinary income goes above $459,750, your capital gains tax increases to 20% — but that’s still lower than your regular tax rate, which would be at least 35% at this point. Any depreciation recapture is still capped at 25%.

The Sweet Spot

I’ve noticed there seems to be a sweet spot where you have the largest proportional tax savings when your earnings are between $170,051 and $459,750. In these cases, your capital gains tax rate is 15% and recapture tax rate is 25% but your ordinary income tax rate would be much higher, between 32% and 35%.

Accelerate Or Not?

You may notice that once you hit the income in Scenario #2 ($170,051), while your depreciation recapture is lower than your ordinary income tax, it is still higher than your capital gains rate. This was something I noticed and began to wonder about. Does it make sense for me to depreciate as much as I can now?

I had been using a cost segregation study to accelerate depreciation as much as possible to have immediate tax savings. But wouldn’t I end up paying an additional 5% to 10% in taxes when I recapture depreciation instead of just waiting and paying the lower capital gains rate?

After thinking about this for a while, I realized it does make sense to accelerate the depreciation, and here is why. While, theoretically, you are losing ground on the gain to the tune of 10% by accelerating, you’re making up most of that ground instantly because you’re getting a deduction now against your current income (which could be taxed at 32% or more). You get these tax savings immediately. The recapture would come at some point in the future, most likely many years from now (at that time your income may even be taxed at a lower rate). Getting the tax savings now, and then paying that back later, was essentially a no-interest loan from the government.

You could use the money that would have gone to paying those taxes to invest in something else. Investing that money wisely could potentially earn more than the difference between the two tax rates. This concept is called positive carry. Let’s say you hold the property for five years. All you need to do is invest in something that produces a 1% – 2% return each year to break even.

What All Of This Means

Remember that it’s essential for you to consult with a tax professional before you act on what I’ve written above. When it comes to passive investments, there are lots of rules around passive losses and gains, and depreciation might not be something you can fully utilize. It is all very nuanced and perhaps that’s why people don’t talk so much about recapture, but it’s something every investor should be aware of! With the right advice and a little bit of planning, you can create a strategy to maximize your gains and minimize your taxes.

The information provided on this website is not advice and does not purport to be a substitute for professional adviceYou should seek out the services of professionals who are experts in the fields of investment, legal, and accounting concerning your specific situation. The author disclaims any responsibility or any liability, loss, or risk, personal or otherwise, which is incurred as a consequence, directly or indirectly, of the use and application of any contents of this website.