Really Trying to understand Depreciation and Recapture upon sale

35 Replies

Hey BP 

I have been thinking a lot about the issue of depreciation on rental properties and what happens when you sell one after a long time without use of a 1031. 

I guess I have been thinking about a property that is owned outright and has no mortgage on it. Lets say you bought with cash ($100K) and held for a long time (28 yrs). Would you actually lose some of the original money used to buy the property  if the market didn't experience and significant appreciation over the 27.5 (life of depreciation) years and sold for $100K? I know you can 1031 exchange and avoid it all. It just makes me think there is an optimal amount of time to hold a property for and sometimes that might not be forever. 

I have not really read many posts about depreciation recapture and what that looks like on the selling end of the investment. So, any words of wisdom or good references for this type of thing would be appreciated. Also if you have experience in doing this, it would be beneficial to hear how it played out for you. 

Conversely, How would this look different if the property appreciated from $100K up to $200K over the lifetime of the investment? I assume cap gains would be another chunk taken from you at the end alongside the depreciation recap.  

Thanks 

well you have to back the lot value out of the 100k scenario so say your improvements were 80k and its fully depreciated.. I am thinking ( and I am no CPA) that you have to recapture the 80k when you sell and pay a portion of tax on what you saved.. and if it went up to 200k that's easy .. you back out sales cost .. your purchase price and any capital improvements that added to basis.. and pay tax on the profit.. 

Where this really bites folks is the small landlord that buys non appreciating assets the small houses don't generate enough cash because they used max leverage so 1031 there is really not enough to 1031 into.. and 

they burn out and just want to sell for some reason.. in these instances in non appreciating markets these folks are certainly going to be writing checks when they sell.. 

I just divested myself of 12 homes I had in MS .. that were 150 to 250k purchase prices and I took a tax hit on recapture.

had I not used Go Zone to buy them in the first place that saved me a bundle this would have been a very poor investment and why do it.. NOTES are much better no recapture and no expense when your paid off.. 

REcapture also is tough with big capital items you buy for your business Like your airplane.. that one sneaks up on a guy.. and there is a big reason that the successful real estate company that has private aviation will usually move up … and if they do sell they have massive recapture so you want to sell that airplane in a down market when you have so loss carry backs to off set.. did this in 2009 post crash we sold one airplane that had I not had some loss carry backs would have been 100k plus to pay tax on .. 

Interesting question, and excellent answer.   Thank you for clarifying recapture, as it has been glossed over here.  Likely because it's not as sexy as most BP topics. 

If we're dealing with a real property placed in service after 1986 we'd encounter "unrecaptured Sec 1250 gain" and not "recapture". Recapture would generally involve tangible property used in a trade or business sold for more than basis. Unrecaptured Sec 1250 gain is taxed at a flat 25%, and is the amount of gain attributable to depreciation taken on the building component. Amounts of gain not attributable to depreciation is a "Sec 1231 gain" and is taxed at your long-term capital gains marginal rate.

Example (ignore land, assume all building for simplicity): Building with a basis of $100k, depreciation of $80k was taken over its lifetime.  $20k tax basis.

  • Sold for $150k: $50k of Sec 1231 gain, $80k of Unrecaptured Sec 1250 gain
  • Sold for $80k: $60k of Unrecaptured 1250 gain
  • Sold for $10k: $10k of Sec 1231 loss (which would be an ordinary loss for tax purposes, much more advantageous than a capital loss)

"Would you actually lose some of the original money used to buy the property if the market didn't experience and significant appreciation over the 27.5 (life of depreciation) years and sold for $100K?"

Don't ignore the tax benefit you received over all those years because of depreciation.  Whether or not your investment performed poorly would be a function of cash flows over asset lifetime, adjusted for the time value of money.

"It just makes me think there is an optimal amount of time to hold a property for and sometimes that might not be forever."

If you're treating it like an investment you're absolutely right. You should be regularly be re-evaluating projected ROI for the next 5, 10 years etc. If there's higher ROI elsewhere (adjusted for risk and level of effort of course), you might want to consider selling and reinvesting to capture that higher ROI. Jay touched on this nicely with note investing.

What area of MS were the properties in @Jay Hinrichs ?  I was born and raised there.

There are two types of recapture.

There is recapture on Section 1250 property -- that's your long-term real depreciable estate (i.e., exclusing land cost). When you sell, you will have to pay 25% of the amount of this type of depreciation that you've taken since acquiring (or building) the improvements.

There also may be recapture on Section 1245 property. For real estate investors this is less common, but it usually comes up if the investor has had their property cost-segregated to take advantage of the shorter depreciation lives the the IRS accepts for many fixtures in and around buildings. These fixtures can include certain types of flooring materials, window coverings, some of the cabinetry, plumbing and electrical systems, any and all land improvements outside the building, and a lot more. When those items are broken out separately after a study is done, they can be written off faster, which is good for reducing income tax. The flip side is that, upon sale, any accelerated depreciation is "recaptured" at ordinary income tax rates. A good accountant usually can soften this blow by analyzing the situation and doing some IRS-acceptable allocations, like when there is carpet as part of the sale but it's worn out and has no more economic value.

There are two ways to defer depreciation recapture: 1031 exchange and monetized installment sale.

Maybe another way is with a Qualified Opportunity Zone but I'm not sure -- still learning about those.

Originally posted by @Eamonn McElroy :

If we're dealing with a real property placed in service after 1986 we'd encounter "unrecaptured Sec 1250 gain" and not "recapture". Recapture would generally involve tangible property used in a trade or business sold for more than basis. Unrecaptured Sec 1250 gain is taxed at a flat 25%, and is the amount of gain attributable to depreciation taken on the building component. Amounts of gain not attributable to depreciation is a "Sec 1231 gain" and is taxed at your long-term capital gains marginal rate.

Example (ignore land, assume all building for simplicity): Building with a basis of $100k, depreciation of $80k was taken over its lifetime.  $20k tax basis.

  • Sold for $150k: $50k of Sec 1231 gain, $80k of Unrecaptured Sec 1250 gain
  • Sold for $80k: $60k of Unrecaptured 1250 gain
  • Sold for $10k: $10k of Sec 1231 loss (which would be an ordinary loss for tax purposes, much more advantageous than a capital loss)

"Would you actually lose some of the original money used to buy the property if the market didn't experience and significant appreciation over the 27.5 (life of depreciation) years and sold for $100K?"

Don't ignore the tax benefit you received over all those years because of depreciation.  Whether or not your investment performed poorly would be a function of cash flows over asset lifetime, adjusted for the time value of money.

"It just makes me think there is an optimal amount of time to hold a property for and sometimes that might not be forever."

If you're treating it like an investment you're absolutely right. You should be regularly be re-evaluating projected ROI for the next 5, 10 years etc. If there's higher ROI elsewhere (adjusted for risk and level of effort of course), you might want to consider selling and reinvesting to capture that higher ROI. Jay touched on this nicely with note investing.

What area of MS were the properties in @Jay Hinrichs?  I was born and raised there.

 Madison    and over on the other side of the reservoir  and a few in Pearl  new construction bought with Go zone bene's which were huge at the time.  exit though was painful.. as they did not appreciate .. 

Thanks for the great responses. Fantastic. It certainly makes it easier to cope with the tax if you know what it is. Certainly many things to consider and important when dealing with proper amount of time to hold the investment. 

@Jeff Glass @Eamonn McElroy

@Jay Hinrichs

Originally posted by @Chris Armstrong :

@Jay Hinrichs apparently I need to look into notes... 

 they have treated us well over the years.

HOwver your in one of the great markets in the US right now.. I have been building infill there for about 5 years now.

and if I was 20 years younger I would pack up and move there its that good.. Love that city... we have 13 projects bought and going through planning right now.. 

Hey Chris,

Depreciation may not be "in the news" on Bigger Pockets or otherwise, but I am learning it can have dramatic positive effects on any income producing real estate property.

I spent the first 40 years of my life developing a wide range of real estate projects. During that time, I built many pro forma spreadsheets and the only line item in them that dealt with taxation was "property taxes". The last 10 years of my life have been devoted to developing utility scale solar projects which deal heavily in taxation issues such as investment tax credits, bonus and MACRS depreciation schedules. 

I recently renewed my activities in real estate which is mostly focused on acquiring and developing multifamily projects. This has has caused me to take a serious look at introducing depreciation into the financial models I build to analyze various projects. 

It is puzzling that little or no attention appears to be paid to depreciation in Realtor's Offering memorandums or Sponsor's projections for projects that are being packaged and sold as LLC shares. Depreciation is a FACT that will have to be dealt with whether it is taken or not for any real estate property and a 25% recapture tax along with capital gains taxes will be due and payable upon the sale of any property held and disposed of after a holding period of 1 year or longer. Failing to take depreciation is foolish in that it provides benefits that enhance project performance. Even if you elect not to take depreciation, you will still have to pay a 25% tax on the depreciation applicable to the property whether it was taken or not.

I began including 27.5 year depreciation to my pro forma models because it is a reality which had a positive effect on raising cash on cash and IRR returns as well as equity multiples. These increases are especially noticeable in the early years of the property's holding period.

I recently began doing a deep dive into the cause and effect of applying cost segregation as a refined method of determining depreciation amounts and its timing. This method significantly affects both the dollar values and their timing which in turn produces significant benefits over and above using a 27.5 year straight-line deprecation schedule.

Cost Segregation involves identifying certain real property assets that can be primarily depreciated in 5, 7 and 15 years. The types of property that fall into these categories are defined by the IRS and can be applied to a property. The best and safest way to know that these factors are being defined and applied correctly is to engage an entity that specializes in conducting what amounts to a forensic engineering study of the property in question. As is the case with any professional service, the quality of their work is directly tied to their experience and integrity, so selecting a qualified engineer plays a big part in the validity of the findings presented and used in the report they produce.

Many Cost Segregation companies offer a "benchmark" study free of charge which will provide a conservative estimate of how much accelerated depreciation will come from segregating depreciable assets. These benchmark reports generally will reflect numbers that will increase if a formal study is conducted. Both the benchmark and formal reports will provide an estimate of the tax savings that can be realized from segregation.

What appears to be missing from most if not all of the Segregation specialist's studies and reports is an analysis that shows the effects the tax savings has on a project's financial performance as measured in industry standard metrics. 

By applying the amounts and timing of the segregated depreciation to the project's cashflows I have found that IRR, cash on cash and equity multiples are improved for both "to be built" and existing properties. One of the principal reasons for these significant boosts to performance has to do with a recent change in the tax codes which allows for 100% bonus depreciation. Specifically, what this provision allows is the ability to take any and all assets that can be depreciated in 20 years or less and write off the entire sum of those assets in YEAR 1 of the project.

By applying the above program, return rates increase by 100's of basis points over not using depreciation at all and or using a 27.5 year schedule. For example, I am working on an apartment project that has a $5,200,000 total cost and a $4,300,000 depreciable cost basis (total cost - land and other non allowable costs). Using a 100% bonus depreciation schedule produces a $1,300,000 depreciation amount in Year 1. In turn, this would result in a tax savings of $450,000 in year 1.

The fact that this savings occurs in Year 1 has a very positive effect on the project's financial performance that cannot be overstated. This injection of cashflow occurs at the time when most real estate projects are showing their lowest income and therefore produces a hit of cash at a time when any project could and can use it the most.

I am in the process of refining pro forma models and vetting these factors and concepts with a CPA that I've used for 10 years for my renewable energy projects to make sure things are as they appear to be. I am also investigating methods of monetizing the tax benefits which could provide a vehicle to introduce equity capital to cover all or a significant portion of the equity required to fund a project.

I would be happy to share my research and analysis to date with anyone interested in learning more about how cost segregation might benefit a project they are working on or just want to learn more about this important set of tools that appear to be widely ignored by the real estate development and investment sectors.

Originally posted by @Barry Ruby :

Hey Chris,

Depreciation may not be "in the news" on Bigger Pockets or otherwise, but I am learning it can have dramatic positive effects on any income producing real estate property.

I spent the first 40 years of my life developing a wide range of real estate projects. During that time, I built many pro forma spreadsheets and the only line item in them that dealt with taxation was "property taxes". The last 10 years of my life have been devoted to developing utility scale solar projects which deal heavily in taxation issues such as investment tax credits, bonus and MACRS depreciation schedules. 

I recently renewed my activities in real estate which is mostly focused on acquiring and developing multifamily projects. This has has caused me to take a serious look at introducing depreciation into the financial models I build to analyze various projects. 

It is puzzling that little or no attention appears to be paid to depreciation in Realtor's Offering memorandums or Sponsor's projections for projects that are being packaged and sold as LLC shares. Depreciation is a FACT that will have to be dealt with whether it is taken or not for any real estate property and a 25% recapture tax along with capital gains taxes will be due and payable upon the sale of any property held and disposed of after a holding period of 1 year or longer. Failing to take depreciation is foolish in that it provides benefits that enhance project performance. Even if you elect not to take depreciation, you will still have to pay a 25% tax on the depreciation applicable to the property whether it was taken or not.

I began including 27.5 year depreciation to my pro forma models because it is a reality which had a positive effect on raising cash on cash and IRR returns as well as equity multiples. These increases are especially noticeable in the early years of the property's holding period.

I recently began doing a deep dive into the cause and effect of applying cost segregation as a refined method of determining depreciation amounts and its timing. This method significantly affects both the dollar values and their timing which in turn produces significant benefits over and above using a 27.5 year straight-line deprecation schedule.

Cost Segregation involves identifying certain real property assets that can be primarily depreciated in 5, 7 and 15 years. The types of property that fall into these categories are defined by the IRS and can be applied to a property. The best and safest way to know that these factors are being defined and applied correctly is to engage an entity that specializes in conducting what amounts to a forensic engineering study of the property in question. As is the case with any professional service, the quality of their work is directly tied to their experience and integrity, so selecting a qualified engineer plays a big part in the validity of the findings presented and used in the report they produce.

Many Cost Segregation companies offer a "benchmark" study free of charge which will provide a conservative estimate of how much accelerated depreciation will come from segregating depreciable assets. These benchmark reports generally will reflect numbers that will increase if a formal study is conducted. Both the benchmark and formal reports will provide an estimate of the tax savings that can be realized from segregation.

What appears to be missing from most if not all of the Segregation specialist's studies and reports is an analysis that shows the effects the tax savings has on a project's financial performance as measured in industry standard metrics. 

By applying the amounts and timing of the segregated depreciation to the project's cashflows I have found that IRR, cash on cash and equity multiples are improved for both "to be built" and existing properties. One of the principal reasons for these significant boosts to performance has to do with a recent change in the tax codes which allows for 100% bonus depreciation. Specifically, what this provision allows is the ability to take any and all assets that can be depreciated in 20 years or less and write off the entire sum of those assets in YEAR 1 of the project.

By applying the above program, return rates increase by 100's of basis points over not using depreciation at all and or using a 27.5 year schedule. For example, I am working on an apartment project that has a $5,200,000 total cost and a $4,300,000 depreciable cost basis (total cost - land and other non allowable costs). Using a 100% bonus depreciation schedule produces a $1,300,000 depreciation amount in Year 1. In turn, this would result in a tax savings of $450,000 in year 1.

The fact that this savings occurs in Year 1 has a very positive effect on the project's financial performance that cannot be overstated. This injection of cashflow occurs at the time when most real estate projects are showing their lowest income and therefore produces a hit of cash at a time when any project could and can use it the most.

I am in the process of refining pro forma models and vetting these factors and concepts with a CPA that I've used for 10 years for my renewable energy projects to make sure things are as they appear to be. I am also investigating methods of monetizing the tax benefits which could provide a vehicle to introduce equity capital to cover all or a significant portion of the equity required to fund a project.

I would be happy to share my research and analysis to date with anyone interested in learning more about how cost segregation might benefit a project they are working on or just want to learn more about this important set of tools that appear to be widely ignored by the real estate development and investment sectors.

I believe real property held for investment ( rental purposes) you don't have a choice you have to take the depreciation..  I am thinking on my airplanes I have bought and used sec 179 that was an election and I believe I could have not taken depreciation on that.  but I am thinking real estate is not an election..  

Pick up a copy of "What Every Real Estate Investor Needs to Know About Cash Flow" by Frank Galinelli. If you can do high school algebra, you can work through the depreciation examples he uses to show how that component affects cash flow in a real estate deal.  

jay

Updated almost 3 years ago

Jay, I believe you are correct and that declaring depreciation on rental property is required. I also believe that the "penalty" for failing to do so is having to pay the recapture taxes whether you claimed it or not.

As a former cost segregation professional I agree that the ability to get the bonus depreciation write-off in year one of ownership is huge in terms of it's potential ROI benefit.

One subtle point to remember is that cost segregation is only applicable to new depreciable basis, so if a property is acquired through a 1031 tax deferred exchange, the investor will not be able to apply cost segregation to the carryover basis from the relinquished property. Instead, cost segregation will be limited to the excess basis. The depreciation system of the carryover basis must be continued on the depreciation schedule for the replacement property. 

Many great explanations here especially from @Jay Hinrichs @Barry Ruby and @Jeff Glass , on a not so popular topic.

One strategy that many accountants use (including some of the Big 4) is reducing the value of the 1245 Property (5 year- personal property) upon sale, even in less than 5 years. This reduces the recapture tax on the value of that property.

@Barry Ruby, I'd be interested understanding what you meant by "What appears to be missing from most if not all of the Segregation specialist's studies and reports is an analysis that shows the effects the tax savings has on a project's financial performance as measured in industry standard metrics." 

If you have 27 years of deferred taxes, paying recapture is a cause for celebration (as are any capital gains).  My W-2 gets hammered by the IRS...but my schedule E is beautiful.

Originally posted by @Mike Dymski :

If you have 27 years of deferred taxes, paying recapture is a cause for celebration (as are any capital gains).  My W-2 gets hammered by the IRS...but my schedule E is beautiful.

it would be a very interesting study to see what the average length of ownership is for land lords .. I suspect those that really grab the bull by the horns and keep rolling up stay at it most of their life but I suppose many that start out smaller with little sfr's if they have some bumps they tend to sell and walk away and try something else. 

I have actually been working on an Excel sheet that includes depreciation recapture and the effect on your profit on the property. i attached part of a screen shot, i am still working on it ( off and on) but what i have come to figure is that there is a time when it is best to sell the property, otherwise you do start losing money.( unless you keep it and have it passed to your heirs). the sample i have on there is a house bought for 110K / 90K loan, as you see the yellow highlight is on a cell that reaches a tipping point on when your income, taxes and depreciation recapture tax / closing costs, would start to "cost" money - you would not make as much upon sale of the property. and i broke it down to 27 years, didn't see a need to have that 1/2 yr in the model.

I also have it to where if you add to the asset ( addition, etc) it will add to the basis and change the numbers, but like i said there are still things i want to work out more and add.

this does not include cost segregation as @Jay Hinrichs ,@Jeff Glass ,@Eamonn McElroy ,@Barry Ruby and @Yonah Weiss have mentioned this is just a straight depreciation on a residential property.

@Patrick Liska I don't really understand your spreadsheet. Let's take line #18

ARV is $120,332.18, but your equity is $251,809.03. Am I missing something?

Also if your ARV column is correct, you are assuming 0.5% appreciation per year. Where did you come up with that?

@Yonah Weiss ,

Thank you for picking that up, i knew the equity was off ( calculations i have to change in the sheet) like i said, this is something i work on now and then, but that does not factor into any of my calculations anyway, that column was more for information. and you are correct that i had appreciation set at .5% ( good figuring) like i said before, this was just a sample that i through numbers into my inputs to run it, this was not any actual property. of course if you had property where mine are, that would be a great year if they rose 1/2% in value, home prices are usually stagnant there, it's the income where you make the money.

Originally posted by @Yonah Weiss :
One strategy that many accountants use (including some of the Big 4) is reducing the value of the 1245 Property (5 year- personal property) upon sale, even in less than 5 years. This reduces the recapture tax on the value of that property.


What support are you seeing them use to justify that their building no longer have +$1M of personal property left in it?  Also are they writing these up as traditional asset sales instead of a standard RE purchase agreement to commit the buyer to a purchase price allocation?  I don't see how they can justify allocating relatively no value to these assets in effort to try to avoid income taxes...  Maybe you offer a back-end cost seg study to come up with new values for the now older assets?

To the OP - depreciation isn't a free deduction unless you plan to hold a property forever.  It typically ends up as a timing difference that lets you deduct a cost in the beginning but you have to reverse it when you sell.  For example if you took $100k of depreciation, you received a tax deduction (or suspended loss) of $100k.  When you sell it, if you sold it at the same price you purchased, you will have $100k of income reversing the depreciation.  Your overall benefit/loss will depend on the difference in tax rates that you took the deduction vs when you pickup the income.  Figure the back end sale can cause a tax bracket increase so the IRS will likely win.

Originally posted by @John Woodrich :
Originally posted by @Yonah Weiss:
One strategy that many accountants use (including some of the Big 4) is reducing the value of the 1245 Property (5 year- personal property) upon sale, even in less than 5 years. This reduces the recapture tax on the value of that property.


What support are you seeing them use to justify that their building no longer have +$1M of personal property left in it?  Also are they writing these up as traditional asset sales instead of a standard RE purchase agreement to commit the buyer to a purchase price allocation?  I don't see how they can justify allocating relatively no value to these assets in effort to try to avoid income taxes...  Maybe you offer a back-end cost seg study to come up with new values for the now older assets?

To the OP - depreciation isn't a free deduction unless you plan to hold a property forever.  It typically ends up as a timing difference that lets you deduct a cost in the beginning but you have to reverse it when you sell.  For example if you took $100k of depreciation, you received a tax deduction (or suspended loss) of $100k.  When you sell it, if you sold it at the same price you purchased, you will have $100k of income reversing the depreciation.  Your overall benefit/loss will depend on the difference in tax rates that you took the deduction vs when you pickup the income.  Figure the back end sale can cause a tax bracket increase so the IRS will likely win.

YUP I have learned this the hard way when exiting my small 12 house portfolio..  if you have no gain in value to off set the depreciation and have to pay sales commission your giving back most of your cash flow at exit if not more than..  Making me wonder why I did this in the first place.. :)  compared to buying a note were the return is more consistent cash on cash as good if not better and no drama ( well selected notes NOT npn those are a ton of work and drama LOL).. then when we get paid off there is no tax.. we paid tax on income as it came in.. we use the note payment to pay the income tax.. and keep the delta

@Patrick Liska This is EXACTLY what I suspected with regard to depreciation recapture. Im glad that you shared this excel sheet thank you. I need to look at it to unpack it but I love the idea of having a model to show the opportune time to sell something or unload it. 

@Jay Hinrichs @Jeff Glass @Eamonn McElroy @Barry Ruby @Yonah Weiss

One more question to you all: The valuation for the land and improvements at the time of purchase is what recapture is based on correct? As you hold the property longer in theory it would appreciate (both the land and the improvements) but that recapture basis does not change over time as well correct, its based on the original purchase valuation?