About Rental Property Depreciation Allowance and Recapture

A depreciation allowance is one of the true tax shelter benefits real estate investors enjoy by owning rental income property because this tax deduction write off can produce positive cash flows and better rates of return.

Of course, there are some not-so-welcomed side effects associate with this real estate investing advantage like depreciation recapture.

So in this article we look at the good, bad and ugly side of depreciation.

Depreciation Allowance

Depreciation allowance is an integral part of real estate investing whereby the IRS tax code assumes that rental property buildings (not the land) are wearing out over time and therefore becoming less valuable.

As a result, the IRS permits income property owners to take a tax deduction for that presumed decline in the form of a depreciation allowance – thus enabling the real estate investor to shelter rental income normally subject to “ordinary income” tax rates.

The amount of allowable depreciation (or cost recovery) that can be written off is determined by what the tax code prescribes to be the rental property’s “useful life”. Namely, the IRS assumes a useful life of 27.5 years for residential property (occupied by tenants as a dwelling) and 39 years for non-residential (commercial) property.

Example

Let’s assume that you purchase a duplex for $500,000 of which $400,000 is attributable to the buildings (the remaining portion is land value). The IRS assumes a useful life of 27.5 years for residential property so you are able to take an annual depreciation allowance deduction of about $14,545.

Source: iCalculator by ProAPOD Real Estate Investment Software

Note: In this case we are referring to the deduction allowed during a full year of ownership. The deduction is slightly less ($13,940) in the first year and selling year due to what the IRS terms the “mid-month convention”.

Benefit

The boon for real estate investors, of course, is that the depreciation deduction is a non-cash deduction — it is not an operating expense.

Therefore rental property owners can take it without having to write a check as they would other costs associated with running the property. Moreover, if the depreciation allowance deduction is large enough to exceed the property’s income, investors can use it to offset other investment income and reduce other tax liabilities as well.

Okay, that’s the good news; now on the flip side.

Depreciation Recapture

Depreciation recapture (sometimes referred to as cost recovery recaptured) is a tax the IRS imposes on the real estate investor when he or she later sells the investment property at a gain.

The IRS assumes that because depreciation was taken during the holding period – thus reducing the investor’s tax basis and effectively increasing tax gain – therefore any gain from a sale may have in part resulted from depreciation allowance and is subject to the cost recovery recaptured (or the recapture tax).

The Taxpayer Relief Act of 1997 currently sets the recapture tax at 25%. Of course, this is subject to change, so always consult your tax adviser when selling real estate investment property.

Example

Say you sell your rental property after taking $609,860 for tax depreciation and show a capital gain of $1,349,560. Since your capital gain is greater than your accumulated tax depreciation the recapture rule would apply and you will owe the IRS $152,465.

Source: ProAPOD Real Estate Investment Software

Suggestion

It’s a good idea to always account for the recapture tax when considering potential real estate investment opportunities. Otherwise, you might be unpleasantly surprised to discover that you owe the IRS more taxes than planned when you subsequently sell your rental property – and that’s not something anyone would want to be surprised with at tax time.