Understanding Depreciation Recapture and The Real Cost of Selling

Here at JB2, we use depreciation creatively to?offset?a lot of the income we are making on the buildings. We also utilize bonus depreciation to further take advantage of the depreciation. Part of the reason our goal is not to sell but hold very long term is to avoid depreciation recapture.

What is Depreciation?

One of the most significant tax benefits of real estate is that the IRS allows you to depreciate rental property, not the land value for each year of ownership up to 27.5 years. This depreciation expense can offset taxable rental income from the property.

For example, let's say you buy property for $120,000. Let's say property value is $100,000 ($20,000 for the land); divide that by 27.5 years, and you get $3,636. Let's say, after all your expenses, your net operating income is $3,636 for the year.?

So, that depreciation expense would offset that rental income, and you would owe no tax. Essentially, it's tax-free income or deferred tax-free income since the IRS will take that back later at the sale with recapturing the depreciation.

Bonus Depreciation

The IRS instituted bonus Depreciation in September of 2017, which essentially allows you to depreciate 20-40% of the depreciable value in the first year. This means you will usually have more losses in the first year to?offset?other income or carry forward to other years. In our?Tax Stack Strategy?e-book, we dig into this concept in further detail. This is important to know because using more depreciation in the front end will significantly increase your recapture tax at a sale.?

What is Depreciation recapture?

Depreciation recapture is the process that occurs when a rental property has been sold. The IRS uses this to collect taxes on your gain from selling income properties. It also recoups any benefits you received by using up depreciation expense to reduce taxable income. Essentially, they are taking back the benefit they previously gave you. So, while you lower your taxable income year after year, you also lower your original cost basis equally.

If we take the example from the above, your original tax basis was $100,000, minus, let's say, after five years of ownership (3,626 X 5)- $18,130 = $81,870 is the new cost basis. Let's say you sell it for double in five years at $200,000. So, take the sale price of $200,000 - $81,870 adjusted cost basis, which equals $118,130 the recognized gain. This is how the IRS recaptures your previous depreciation expense.?

The other caveat is the $18,130 recaptured depreciation is taxed as ordinary income. So, in this example, you multiply the depreciation expense of $18,130 X 24% (2021 tax rate for married making between $172,751 to $329,850) equals $4,351 taxes owed. Then you would take the rest of the $100,000 gain and multiply it by the long-term gain tax rate of 15%, which equals $15,000. So, the total taxes owed on this example sale is $19,351. This?article?and?video?go into some more details here. As you can see, offsetting rental income with depreciation expense is no free lunch if you ever sell.

1031

"Thanks to IRC Section 1031, a properly structured 1031 exchange allows an investor to sell a property, to reinvest the proceeds in a new property and to defer all capital gain taxes." -API exchange

All this is proof why not selling or performing a 1031 is a sound financial decision. By not selling or performing a 1031, we avoid paying all the tax burden. We also avoid paying back that depreciation expense. This is also why we usually hold for 27.5 years when depreciation runs out. Here at JB2 Investments, our goal is to do a refinance instead of sell in hopes that those tax-free refi proceeds are similar to what you would have after the gain from a sale minus the tax burden.

There may be a rare occasion where it does make sense to sell outright. If for example, we got an incredible price to sell, perhaps it doesn't make sense to buy right away because of market conditions. Hopefully, we have enough carried losses from other properties to offset any of these potential gains anyways. Hopefully, what we made abundantly clear here is the actual consequence of selling and why holding longer-term makes a lot of sense.