How Depreciation is Recaptured

[Dave Toelkes]

Investors have long known that depreciation on depreciable real estate is an economic fiction. Since property values usually increase over time, depreciation has often been called a "phantom" expense. Congress even recognized this fact and instituted changes to the US tax code that introduced what is known as "depreciation recapture."

Suppose you buy $75,000 of depreciable real estate and depreciate it by $10,000 during your holding period. The property's book value (cost minus depreciation taken) would then be $65,000.

Now by selling the property for anything more than $65,000, you demonstrate that your $10,000 of depreciation was a phantom expense. The property did not depreciate at all -- it went up in value.

If you sell the property for between $65,000 and $75,000, the amount of the selling price that exceeds $65,000 is the amount of depreciation that DID NOT really occur. Depreciation that did not really occur is said to be "recaptured" at the time of the sale. You must pay tax on it to make up for the deductions you took (or should have taken) previously.

Consider the following examples. In each case, an investment property is purchased for $100,000 and depreciated by $20,000 during the holding period -- reducing the book value to $80,000 at the time of sale.

Case 1: The property is sold for $120,000 or $20,000 more than the original cost. The taxable gain on this sale (sale price minus book value) is $40,000. The first $20,000 of this gain is depreciation recapture, and the rest is a capital gain.

Case 2: The property is sold for $92,000. The sale proceeds exceed the book value of $80,000, but do not exceed the original cost of the property. In this case, the $12,000 of gain on the sale is considered a depreciation recapture and there is no capital gain. The reader should note that although the property was sold for less than its original cost, there is no loss for tax purposes because the property was sold for more than its book value.

Case 3: The property is sold for $76,000 which is $4,000 less than its book value at the time of the sale. There is no depreciation recapture and no capital gain. Instead, there is a capital loss of $4,000.

Currently, the depreciation recapture tax rate is 25%, while the maximum long-term capital gains tax rate is 15%.

[Niman S.]

I wrote an article about Accelerated Deductions and Depreciation Recapture - it was published in Invest Magazine in November. A Canadian viewer contacted me and asked if it was possible to accelerate depreciation on business assets the same way that it can be done on income property. I told him absolutely - but the benefit depends on the recapture tax.

As it turns out, depreciation works differently in Canada. Canadians don't have to depreciate, they can catch up on deductions any time, and they only recapture what they've deducted. So why would they even do it?

Americans HAVE to deduct depreciation, and we HAVE to recapture @25%, so it benefits us to take more now and make the most of it.

Since we must recapture anything that gets deducted, would you deduct anything at all if you didn't have to?

[Dave Toelkes]

Yes, component segmentation can allow you to take a larger depreciation deduction in the early years of property ownership, but if you never sell the property the total depreciation allowed over 27.5 years with component segmentation will be the same as the depreciation allowed without component segmentation.

Component segmentation allows you to take a larger depreciation expense in the first 15 years of ownership. In the next 12.5 years, the component segmentation depreciation will be lower than the allowed depreciation without segmentation.

So, if the investor's intent is to hold the rental property indefinitely, the depreciation approach is irrelevant because it all works out the same in the long run.

Given the above, I take exception to your comment in the article that "with "straight" line depreciation, we get the same deduciton every year -- meaning our depreciation deduction in year three is the same as the depreciation deduction in year twenty-three." You completely ignore that five year property still gets replaced, and when replaced a separate depreciable asset with a 5 year depreciation schedule is included in the depreciation expense. In fact, in year twenty, you would be depreciating the original basis in the dwelling structure, plus any five year property that had been replaced in the previous four years, plus any 15 year property that might have needed replacement in the prior 14 years.

In the twentieth year of the "straight line" depreciation schedule, it is conceivable that the total depreciation expense is greater than what would be taken under a segregated component depreciation schedule. This is why the two techniques generally work out to the same total depreciation expense over the 27.5 year class life of the dwelling structure.

I was disappointed that your article did not mention that land is not depreciable. Instead, your example of the home purchased for $165K producing a $6K depreciation expense misleads the uninformed reader to believe that land is depreciable. You reinforce this misconception again by stating that a $275K property yields a $10K annual depreciation deduction.


Since we must recapture anything that gets deducted, would you deduct anything at all if you didn't have to?

If we assume that the income tax outcome on the sale of a rental property will be the same for a depreciated property as for a property for which no depreciation were taken, then some investors will depreciate, others will not. It is a matter of how much effort someone is willing to expend to achieve the same long term outcome, even though short term results may differ.

I suppose you will get the same answer if the question were -- will you segregate components for a larger depreciation expense even though you don't have to?

[Niman S.]

I agree Dave, you are absolutely right, and you've brought up some very important points - ie. land does not depreciate, short-life assets can be replaced and depreciated too, and all methods will yield the same cumulative deduction if the property is held that long - most of these complexities were edited out of the article to make it a more simple read for viewers. For example, I originally wrote the property had a basis of $165k, capital improvements, I explained the recapture, etc... but the editor had the final cut.... Although me and you may know the ins and outs of depreciation, the subject can get too complex for most readers.

Where I disagree is that "if the investor's intent is to hold the rental property indefinitely, the depreciation approach is irrelevant because it all works out the same in the long run."

I agree that If I am holding property indefinitely, the recapture tax is of no concern to me (who knows if or when I sell), and the same amount of depreciation will get deducted over time regardless of which method is used. However, since a dollar now is worth more than a dollar 1 year from now, and a tax deduction is worth more to me now than it is later - I'd rather take the deduction now. Assuming I never sell the property, maximizing and accelerating deductions will have been the best choice. Only if I were to sell the property within the early years would I regret the accelerated deductions (and only because of the 25% recapture)

[Elias Valdez III]

Very informative! Thank You for your time to expound in this subject.