Depreciation Recapture in Residential Real Estate Investing
Key Points
Residential real estate rentals can be a great investment provided you understand all the tax implications.
Annual reporting and management of rental property typically requires some enhanced tax and account support for most investors.
Investors considering a sale of residential real estate rental property need to familiarize themselves with the tax consequences of that sale planning, specifically as it relates to both capital gain and recapture gain exposure.
When looking to diversify your investment portfolio, you may be considering real estate, specifically residential rentals. “Residential real estate rental” is a typical asset class for investors to hold as part of their overall portfolio. While many find success in real estate investing, it does come with complications you’ll want to consider before diving in. Here, we’re focusing on one of those added complications, depreciation and depreciation recapture.
Depreciation While Renting Residential Real Estate
Before doing anything, you’ll want to know and consider the tax implications. When investors rent out residential rental properties, the Internal Revenue Service (IRS) allows the investor to depreciate the property. The depreciation is taken over a 27.5-year period, or roughly 3.6% per year. As the owner, you may benefit from taking depreciation as an expense on your income taxes. In addition, you can deduct expenses related to operating the rental property, thereby, offsetting and reducing your taxable income. As time goes on, the amount of depreciation taken (or accumulated) can become quite significant as can the amount of income you’ve been able to offset.
Recapture Depreciation When Selling Real Estate Rentals
When planning to sell a rental property, you’ll want to begin to assess the expected income tax bill that will be due on the property’s sale. Typically, this is done by determining the expected sale price less your purchase price. While this is a good starting point, when assessing income tax consequences from the sale of rental property that has been depreciated, you’ll need to go a step further and determine what the accumulated depreciation on the property has been leading up to the sale.
The reason this is needed is because there is a separate gain calculation that’s done on depreciated property. To assist with this planning and its related reporting, you’ll use IRS form 4797. This form is used to report the depreciation portion of the gain, known as recapture depreciation.
Recapture depreciation gain is taxed at the lesser of the investor’s ordinary income tax rates or a tax rate of 25%. If there’s an additional gain on the property above and beyond the recapture gain, that profit is then taxed at the capital gains rates, which can range from 0–20% based on the investor’s tax bracket for the year.
Recapture gain planning adds some extra complexity to the planning and reporting requirements related to the sale of rental property. However, with the relevant information and time, these additional considerations can and should be evaluated, preferably before moving ahead with formal transaction planning.
Investors considering a sale of residential real estate property need to familiarize themselves with the tax consequences of that sale planning, specifically as it relates to both capital gain and recapture gain exposure.
It’s these types of nuances that can easily surprise even the savviest investor. Our expertise at Capstone lies in managing investment portfolios that often include various real estate assets. Because we consider tax implications in every recommendation we make, you’ll feel confident everything’s been accounted for.
Disclosures:
This article is not a substitute for personalized advice from Capstone and nothing contained in this presentation is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. This article is current only as of the date on which it was sent. The statements and opinions expressed are, however, subject to change without notice based on market and other conditions and may differ from opinions expressed by other businesses and activities of Capstone. Descriptions of Capstone’s process and strategies are based on general practice, and we may make exceptions in specific cases. A copy of our current written disclosure statement discussing our advisory services and fees is available for your review upon request.