Understanding the Depreciation Recapture Tax

If you’re about to sell a rental income property that you’ve owned for more than one year then prepare to pay the Feds a depreciation recapture tax to spare yourself an unpleasant surprise at tax time. Because most real estate investors will have to deal with it once they sell their investment.

It seemed needful, therefore, to discuss depreciation recapture for those of you who are new to real estate investing and might not be aware of how the Internal Revenue Service will impose this tax upon you following a sale. We’ll consider the meaning, method and rationale used by the IRS to impose it.

What It Is

Depreciation recapture is the procedure used by the IRS to “recapture” income tax on a gain realized by a real estate investor when he or she disposes of a rental property that had previously provided an offset to his or her ordinary income through depreciation.

In other words, it’s a tax associated with the “depreciation allowance” write-off that you’ve been enjoying at tax time for each of the years that you’ve owned the property.

How it Works

When you sell an income property you’ve owned longer than one year and have a recognized gain, the feds will tax you for the accumulated depreciation deductions you’ve taken during the years you owned the property.

Their contention being that since you were able to realize a capital gain by reducing your tax liability with allowable depreciation deductions while you were holding the investment, the Feds expect you to pay some of it back now that you’re disposing of the investment.

Their rationale is fairly straightforward.

The IRS does not want to allow you to simply pay the generally more favorable (15-20%) capital gains tax rate on your entire gain, but instead, also wants to collect the currently higher recapture tax of 25% on a portion.

Let’s do some math to show how this could impact your tax obligation.

Let’s say, for example, that you sell your rental property after owning it for five years and realize a gain of $1,959,420 of which $609,860 is attributable to the depreciation you’ve taken during that holding period.

sale with depreciation recapture

click to enlarge

Okay, now let’s assume a depreciation recapture tax rate of 25% and a capital gains tax rate of (say) 20%.

1. If your entire $1,959,420 gain were merely taxed at the capital gains rate you would owe the Feds (1,959,420 x .20), or $391,884 .

2. Because of recapture, however, your accumulated depreciation of $609,860 gets taxed at the higher 25% rate and only your adjusted capital gains of $1,349,560 (1,959,420 – 609,860) gets taxed at the lower 20% rate. In this case you owe the Feds $422,377.

In other words, thanks to the depreciation recapture tax you wind up owing the IRS $30,493 more in taxes than you would have had the tax not been imposed.

So You Know

ProAPOD Real Estate Investing Software automatically calculates depreciation, recapture tax, capital gains tax, and tax obligation.