Depreciation Recapture ~ Understanding the Tax Impact on Investment Property

There is a long list of ben­e­fits of own­ing invest­ment real estate. If and when you sell your invest­ment prop­er­ty, you may be unaware of many of the tax impli­ca­tions you may be exposed to as an investor. Once you see the list of poten­tial tax­es due on a fed­er­al, and a state basis you may be a lit­tle con­fused.

By Al DiNi­co­la, AIF®, CEPA ™
adinicola@namcoa.com
August 10, 2023
DST 1031 Spe­cial­ist
NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC
Secu­ri­ties offered through MSC-BD, LLC

There are a vari­ety of words asso­ci­at­ed with the poten­tial tax impli­ca­tions such as depre­ci­a­tion, depre­ci­a­tion recap­ture, cap­i­tal improve­ments, cap­i­tal gains, and oth­ers that come into the dis­cus­sion. For first-time investors it is wise to know these words and be aware of the poten­tial tax­es.  There may be ways to avoid the imme­di­ate pay­ment of these poten­tial tax­es.

Does Real Estate Real­ly Depre­ci­ate?

This is an inter­est­ing dis­cus­sion based on the the­o­ry that real estate appre­ci­ates and many look at real estate as build­ing wealth. Investors with rental prop­er­ties are per­mit­ted by the IRS to uti­lize the IRC Codes to recov­er cer­tain costs over the life of real estate own­er­ship. The cost must be deduct­ed over the life of own­ing the prop­er­ty based on a depre­ci­a­tion sched­ule.  Res­i­den­tial sched­ule is over 27.5 years and all com­mer­cial is over 39 years. Many investors sim­ply use a straight-line depre­ci­a­tion sched­ule.  (The 2017 JOBS act did allow for cost seg­re­ga­tion with addi­tion­al accel­er­at­ed write offs). Raw land does not qual­i­fy for depre­ci­a­tion. The val­ue of the land under the real estate is also not able to be depre­ci­a­tion.  As a sim­ple exam­ple a res­i­den­tial rental prop­er­ty may have an under­ly­ing land val­ue of 15% of the acqui­si­tion price.  That would mean the depre­ci­a­tion would be based on 85% of the acqui­si­tion price.  Investors look at depre­ci­a­tion as one of the many advan­tages of own­ing real estate.

The depre­ci­a­tion is a write-off against the income received from the invest­ment prop­er­ty that will reduce the amount of income from the invest­ment prop­er­ty that is poten­tial­ly taxed. To illus­trate the effect of depre­ci­a­tion let’s assign some num­bers to the real estate invest­ment.  You acquired a sin­gle-fam­i­ly home on June 30^th at an acqui­si­tion price of $550,000 and you added $50,000 in cap­i­tal improve­ments by adding a garage and improv­ing the kitchen which brings your total invest­ment to $600,000.

Know Your Basis

Pur­chase price and cap­i­tal improve­ments are referred to as your cost basis.  As not­ed pre­vi­ous­ly you need to reduce your start­ing depre­ci­a­tion amount by the val­ue of the land.  The land val­ue (for exam­ple) is $50,000. This reduced the val­ue of the struc­ture to $550,000. When uti­liz­ing the straight-line method, you would divide the $550,000 by the annu­al res­i­den­tial depre­ci­a­tion of 27.5 years.

Here is an exam­ple of the cal­cu­la­tion:

• $550,000 divid­ed by 27.5 years would be $20,000 (esti­mate) per year in depre­ci­a­tion on an annu­al basis. 
• Since the prop­er­ty was acquired June 30 the first-year depre­ci­a­tion would be approx­i­mate­ly $10,000.

The acqui­si­tion cost (minus the val­ue for the land) and the cap­i­tal improve­ments made on the prop­er­ty estab­lish the basis for depre­ci­a­tion. A word of cau­tion regard­ing depre­ci­a­tion would be that the IRS assumes you are tak­ing depre­ci­a­tion each year regard­less if you actu­al­ly uti­lize on your tax returns.  Most CPAs are aware of this sit­u­a­tion.

Depre­ci­a­tion recap­ture and the poten­tial tax.

IRC § 1250 illus­trates the recap­ture of depre­ci­a­tion once the prop­er­ty has been sold. We have used 27.5 years in our illus­tra­tion.  If the investor owned a ware­house or oth­er com­mer­cial build­ing the depre­ci­a­tion would be over 39 years.  The IRS con­sid­ered the depre­ci­a­tion tak­en over the years of own­er­ship as a GAIN. The depre­ci­a­tion reduced your tax­able income you received from the rental prop­er­ty. The depre­ci­a­tion also reduced your cost basis.

Con­grat­u­la­tion you sold your prop­er­ty, now what?

When you final­ly sell the prop­er­ty (after enjoy­ing the depre­ci­a­tion write-offs) a por­tion of the depre­ci­a­tion tak­en will need to be paid back to the IRS. After own­ing the prop­er­ty for over ten (10) years you decide to sell for $800,000. You pur­chased the prop­er­ty for $600,000 (includ­ing $550,000 pur­chase price and $50,000 in cap­i­tal improve­ments). You are clos­ing on Decem­ber 31.

Depre­ci­a­tion & Cap­i­tal Gains Cal­cu­la­tion.

Here is the total depre­ci­a­tion tak­en over the 10 plus years.  Remem­ber year one was $10,000 and each full year was $20,000. The grand total of depre­ci­a­tion tak­en was $210,000.  This num­ber is impor­tant and is used in two cal­cu­la­tions.

• Cal­cu­la­tion 1 is the depre­ci­a­tion recap­ture.  For­tu­nate­ly, the IRS recap­tures the depre­ci­a­tion at 25% and not at 100%. The depre­ci­a­tion recap­ture would be $52,500 due to the IRS. Your tax pro­fes­sion­al will know how to report on IRS Form 4797.
• Cal­cu­la­tion 2 estab­lish­es the adjust­ed cost basis. The depre­ci­a­tion of $210,000 is sub­tract­ed from the build­ing val­ue of $550,000 to arrive at an adjust­ed cost basis of $340,000. This adjust­ed cost basis is used to deter­mine your cap­i­tal gain on the prop­er­ty.  You have accept­ed an offer to sell the prop­er­ty for $800,000. Your cap­i­tal gain sub­tract­ing the adjust­ed cost basis is $460,000.
• How your tax respon­si­bil­i­ty is cal­cu­lat­ed includes one more cal­cu­la­tion. Since depre­ci­a­tion is taxed at the 25% rate the depre­ci­a­tion amount is sub­tract­ed from the cap­i­tal gains to estab­lish the long-term cap­i­tal gains.  As cal­cu­lat­ed the depre­ci­a­tion tak­en was $210,000 and when sub­tract­ed from the total gain of $460,000 leaves an amount of $250,000.  This would be tax­es at a cap­i­tal gains rate of 20% or $50,000. This added to the $52,500 would be a total of $102,500. 

There is one more tax for high­er income earn­ers.  The is a Net Invest­ment Income tax (NIIT) of 3.8% on the entire gain of $460,000. This is $17,480.

Don’t for­get your state income tax.  If you reside in a state with a state income tax, that tax is also due on the cap­i­tal gain of $460,000. For this illus­tra­tion let’s use 5% which may be an addi­tion of $23,000.

The grand tax total may be $142,980.

IRC §1031 per­mits defer­ral of cap­i­tal gains as well as depre­ci­a­tion recap­ture.

Many real estate investors will uti­lize the 1031 tax deferred exchange sec­tion of the inter­nal Rev­enue Code.  This sec­tion has been used by many to accu­mu­late and build gen­er­a­tional wealth. If you sell a prop­er­ty out­right the IRS requires the report­ing and pay­ment of applic­a­ble tax­es.

There are a num­ber of stip­u­la­tions and guide­lines that need to be adhered to for the 1031 com­pli­ance.  How­ev­er, here is a com­par­i­son between an out­right sale and a 1031 exchange. You may here the terms like kind exchange and uti­liz­ing a Delaware Statu­to­ry Trust (DST) as an alter­na­tive to tra­di­tion­al real estate. We have oth­er arti­cles that focus on the 1031 guide­lines as well as replace­ment strate­gies uti­liz­ing a 1031. Please con­tact us for more infor­ma­tion.

	Tax­able Sale	1031 exchange
Sale Amount	$800,000	$800,000
Cap­i­tal Gain Tax­es	$50,000	Deferred
Depre­ci­a­tion Recap­ture Tax	$52,500	Deferred
NIIT	$17,480	Deferred
State Tax	$23,000	Deferred
Rein­vest­ment Pro­ceeds	$657,020	$800,000
Total Tax­es Due	$142,980	$0

The tax­es that may be due in the amount of $142,980 could be deferred by uti­liz­ing the IRC §1031 Tax Deferred Exchange. You will notice under the Tax­able Sale col­umn there would be $657,020 to rein­vest.  Under the 1031 Exchange you may rein­vest the entire amount of $800,000.

DSTs are not for all investors.

The acqui­si­tion of a DST is for accred­it­ed investors only. Con­tact your invest­ment advis­er for addi­tion­al details on how a DST may be a solu­tion to your 1031 Exchange and suit­ed for your invest­ment future. For more infor­ma­tion on how to prop­er­ly set up an IRC 1031Tax Deferred Exchange or if you are an accred­it­ed investor and would like addi­tion­al infor­ma­tion on a DST con­tact Al DiNi­co­la at 239–691-8098 or email adinicola@namcoa.com.

This is not an offer to pur­chase or solic­i­ta­tion to pur­chase any secu­ri­ty, as such be made only through an offer­ing mem­o­ran­dum or prospec­tus. Invest­ing in secu­ri­ties, real estate, or any invest­ment, whether pub­lic or pri­vate, involves risk, includ­ing but not lim­it­ed to the poten­tial of los­ing some or all of your invest­ment dol­lars when you invest in secu­ri­ties. You should review any planned finan­cial trans­ac­tions that may have tax or legal impli­ca­tions with your per­son­al tax or legal advi­sor. NAMCOA, LLC is a Reg­is­tered Invest­ment Advi­sor, reg­u­lat­ed by SEC (Secu­ri­ties and Exchange Com­mis­sion). Our cor­po­rate office is locat­ed at 999 Van­der­bilt Beach Road, Suite 200, Naples Flori­da 34108. Secu­ri­ties Offered through MSC-BD, LLC, Mem­ber of FINRA/SIPC. 8215 SW Tualatin ‑Sher­wood Rd, Suite 200 Tualatin, OR 97062. MSC-BD, LLC and NAMCOA are inde­pen­dent­ly owned and are not affil­i­at­ed.

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