What Does Depreciation Recapture Mean And How Does It Affect Your Taxes?

In other articles on this blog, we’ve covered how to depreciate buildings, additions and improvements, and personal property.  

But what happens with depreciation when you sell an investment property? 

In short, it’s “recaptured.” But how exactly does this work and what does this mean?  

In this article, we’re going to answer those questions. 

Determining the Adjusted Cost Basis 

Before we go any further, we need to start with the adjusted cost basis. When you first buy depreciable property, you set up a cost basis. This is the starting value of the asset from the Internal Revenue Code (IRS) perspective. As time goes on, this amount changes to more accurately reflect the asset’s true value. This updated value is referred to as the adjusted cost basis. 

You’ll need this adjusted cost basis when you sell your property. 

For example, let’s say you dramatically improved your rental property during your time as owner. You replaced the HVAC system, put in a new pool, and installed new lighting. Essentially, you improved the property noticeably compared to its original condition. As a result, the property is worth more than it was back when you purchased it (i.e., it appreciated), and its cost basis needs to reflect this fact. 

It’s important to note that a number of things can increase or decrease the cost basis. Anything that adds to your property’s value will create an increase in the cost basis, such as improvements, restorations, or extensions of utility service lines. On the other hand, anything that decreased its value, such as casualty loss not covered by insurance, will need to be subtracted from the cost basis. 

You also need to take depreciation into account, which is the most substantial subtraction you will take out of the cost basis. (It’s often the most complex to understand, but we have other articles on depreciation to help you learn more).  

When you sell your property, the IRS doesn’t want you to use your purchase price (also known as the original cost basis) to figure out how much you gained or lost. Instead, it uses the adjusted basis. So, the formula ends up looking like this: 

profit = sales price – adjusted cost basis 

Why is this formula important? The adjusted basis helps determine your profit, which is the amount the government taxes. A higher adjusted basis means lower profit, which means less capital gains tax. A lower basis means more profit and higher tax. A portion of that tax can be attributed to those depreciations you subtracted from the cost basis. This portion is called recapture, which we’re going to discuss next. 

Calculating Recapture 

Recapture of depreciation is a complicated topic. However, it’s vital to understand why you will eventually be taxed for depreciation deductions.  

Let’s say you’re ready to sell your property, and you’ve calculated the adjusted cost basis. Now you want to decide on a sales price for your property. Obviously, you want to turn a profit. You don’t want to sell it for the same price you purchased it, and you also don’t want to sell it at the readjusted basis amount.  

Before we go further, take another glance at the profit formula from earlier. Your profit from the sale is the difference between the selling price you land on and the adjusted cost basis. Because profit partially relies on the adjusted basis, additions or subtractions to the basis impact your profit number. 

Depreciation is a massively influential variable in this formula because it’s a hefty subtraction. You subtract it because you paid for those assets, but then you recovered the costs as time went on through depreciation deductions. Depreciation is a return on your investment, so it lowers the adjusted basis and raises taxable income profit. 

The part of your profit correlated to depreciation is called recapture. The IRS uses recapture to recover your depreciation deductions, which are taxed at a 25% rate. The remaining portion of your sales gain is taxed at the regular capital gains rate.  

At this point, you may be frustrated. What is the advantage of depreciation deductions if the IRS takes all of it back later? Recall, though, that property usually appreciates over time. Depreciation was always just a short-term deferral of your taxes, but that doesn’t make it any less beneficial. Also, it’s important to note that depreciation is assumed. In other words, you’ll get taxed for it whether or not you take deductions, so it’s always in your best interest to take them. 

If this all still sounds a little confusing, don’t worry. It’s always smart to work with a tax professional when you sell your property to ensure you pay the proper taxes on the sale.  

One simple thing to always keep in mind: The more you depreciate, the more money you’ll get from the sale, and the more you’ll pay when it comes to taxes. 

Special Circumstances 

Alas, there are a few exceptions to the description of property sales tax we’ve just gone over. These particular circumstances are Like-Kind Exchanges and the Home Sale Exclusion. 

Like-Kind Exchanges 

If you exchange your real property for similar real property in America, you don’t need to pay tax on the transaction. This is because you postpone paying taxes until you sell your new property. 

These exchanges are quite complicated. If you’re involved in an exchange, you keep the cost basis of your original property. Especially complex exchanges require a Qualified Intermediary (QI) to mediate between buyers and sellers. 

For detailed information on like-kind exchanges, go to Section 1031 of the tax code. Also, if you’re involved in a like-kind exchange, enlist professional tax help. 

Home Sale Exclusion 

The Home Sale Exclusion offers landlord tax breaks if the property you sell is your principal home. You can subtract up to $250,000 of the home sale profit from your income before your income tax applies (or $500,000 if married and filing jointly). 

A place of residence counts as your “principal home” if you own and treat it as your primary residence for two out of the five years leading directly up to the sale. Many landlords make the most of this exception and avoid depreciation recapture at least in part by living in the property for two years, then renting it out for three years prior to selling it. 

Conclusion 

Recapture is a vital concept to understand for landlords. If you sell a property, it behooves you to know how to navigate the tax situation. 

Always be sure to work with a professional when you sell the property. There are nuances to the process, and it’s better to be safe than sorry.