Property Depreciation: Why the Tax Benefits Could Come Back to Bite You

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When you purchase a new rental or commercial property with investment intent, you must allocate a portion of the purchase price to improvements and the remaining amount to land. The reason for this practice is that you cannot depreciate land, only improvements. This makes sense because dirt lasts forever.

Depreciation is the reduction in value of a property over time due to the particular wear and tear on the asset. Residential properties are depreciated over 27.5 years, while commercial properties are depreciated over 39 years.

This reduction in value is a current expense, yet no money comes out of your pocket. Sounds like a pretty awesome deal, right? You get to reduce your reported income by your annual depreciation expense without actually paying for anything!

But what is depreciation really? Do you think the IRS, our favorite government agency, would let you have it that easy? I’ll give you a hint: the answer starts with the letter “N” and ends with “O.”

In actuality, depreciation is similar to an interest free deferred loan with no time restrictions. You see, when you sell a property that you have been depreciating, you have to pay a thing called “depreciation recapture taxes” at a 25% rate. This 25% rate is multiplied by the total value of depreciation you have taken over the property’s hold period. So the income you are “sheltering” each month really isn’t being sheltered like you think it is, as you will eventually have to pay a portion of it back. Without prior knowledge (or having a good accountant), you could be in for quite the surprise!

I’m going to walk you through three scenarios of taxpayers in different marginal tax brackets: the 15% bracket, the 25% bracket, and the 28% bracket. I’ll then provide you with three ways to avoid depreciation recapture taxes.

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The Taxpayer in the 15% Bracket

Dave buys a single family rental for $100,000 and determines that his improvement ratio is 90%. Therefore, his improvements are valued at $90,000 (0.90 x $100,000) and will be his cost basis for depreciation. Dave’s annual depreciation will be $3,723 ($90,000/27.5).

Assuming that his annual depreciation brings his Net Operating Income (NOI) to $0.00 each year, Dave saves $491 annually (0.15 x $3,723). If Dave holds the property for ten years and then sells it, his ten years’ worth of depreciation will have saved him $4,910, a solid savings indeed.

But what Dave doesn’t realize, likely because Dave didn’t consult with a real estate savvy accountant, is that Dave has to repay the total depreciation taken at a 25% rate. The total amount of depreciation Dave took over ten years was $32,730, meaning his recapture taxes amount to $8,183. Annual depreciation actually costs Dave $3,273.

Depreciation Recap 1

The Taxpayer in the 25% Bracket

Dave buys a single family rental for $100,000 and determines that his improvement ratio is 90%. Therefore, his improvements are valued at $90,000 (0.90 x $100,000) and will be his cost basis for depreciation. Dave’s annual depreciation will be $3,723 ($90,000/27.5).

Assuming that his annual depreciation brings his Net Operating Income (NOI) to $0.00 each year, Dave saves $818 annually (0.25 x $3,723). If Dave holds the property for ten years and then sells it, his ten years’ worth of depreciation will have saved him $8,183.

Related: Yes, You CAN Write Off Your Depreciation: Here’s How

The total amount of depreciation Dave took over ten years was $32,730, meaning at a 25% rate, his recapture taxes amount to $8,183, which is a net $0 savings. Because Dave consulted with a real estate savvy accountant, Dave knew he would owe nothing in depreciation recapture taxes and was essentially getting an interest free loan on his money.

Depreciation Recap 2

The Taxpayer in the 28% Bracket

Dave buys a single family rental for $100,000 and determines that his improvement ratio is 90%. Therefore, his improvements are valued at $90,000 (0.90 x $100,000) and will be his cost basis for depreciation. Dave’s annual depreciation will be $3,723 ($90,000/27.5).

Assuming that his annual depreciation brings his Net Operating Income (NOI) to $0.00 each year, Dave saves $916 annually (0.28 x $3,723). If Dave holds the property for ten years and then sells it, his ten years’ worth of depreciation will have saved him $9,164.

The total amount of depreciation Dave took over ten years was $32,730, meaning at a 25% rate, his recapture taxes amount to $8,183, which amount to a savings of $982. Basically, the IRS loves Dave so much they decided to pay him a premium for the money they were lending him over the past ten years. And who said the IRS doesn’t care about us?!

Depreciation Recap 3

We Can Make This More Complicated

Due to inflation, the real value of your annual savings will diminish. So in order to increase the accuracy of our model, to “break even” in respect to inflation, you will need to account for the reinvestment of your savings from depreciation at somewhere around a 2.5% annual rate of return.

Additionally, we can break the model out on a monthly basis rather than an annual basis to gain a clearer picture of what is actually going on. We can model what would happen if we reinvest our annual savings into various investment vehicles over the hold period to develop a strategy that makes sense and best utilizes depreciation savings. But that’s all beyond the scope of this article.

Moral of the Depreciation Story

Being in a low tax bracket actually hurts the taxpayer in respect to depreciation expense. Fifteen percent Dave should have tried to minimize his annual depreciation expense, which really boils down to how much of the purchase price he allocates to improvements vs. land. If Dave’s research could have supported a higher land valuation, he would have been better off to go that route.

This can be a double edged sword, though. If Dave’s rentals push him into the 25% tax bracket, Dave will then want to take more depreciation, as seen in the next scenario.

On the other end of the spectrum, 28% Dave fares quite well in respect to depreciation and should try to utilize the highest improvement ratio he can support to shelter even more of his income per month. Since 28% Dave only pays the IRS back at a 25% rate, he will come out on top.

And of course 25% Dave is just excited to get an interest free loan. He thought lenders did away with that years ago.

Avoiding Depreciation Recapture Taxes

There are three good methods of avoiding depreciation recapture taxes.

The first option is to utilize a 1031 exchange. Doing so will allow you to defer paying depreciation recapture taxes, as a 1031 exchange allows you to roll the depreciation into the next property. The downside here is that you are merely deferring your depreciation recapture tax liability and will have to pay the recapture taxes upon the sale of the exchanged property at some point in the future.

The second option is to never sell your properties and pass them on to your heirs. When your heirs inherit your investment property, they receive a “stepped-up basis” equal to market value at the date of death, or if they elect this option, the market value six months after the date of death. This means that your heirs will not have to pay your depreciation recapture taxes or capital gains from your original purchase price.

To illustrate, let’s assume you pass on a fully depreciated property to your heirs. Over the years, you benefitted from $90k of depreciation, and if you would have sold, you would have owed $22,500 in depreciation recapture taxes. Due to the stepped-up basis your heirs receive, that depreciation is wiped clean, and their cost basis will be the fair market value at the date of death. Even better, if it’s still a rental, they can begin depreciating it all over again.

Related: The Ultimate Guide to Real Estate Investment Tax Benefits

The third option (which is not so popular) is to sell the property at a loss. Gains are calculated by subtracting the property’s adjusted basis from the selling price. Adjusted basis generally means original purchase price plus improvements, less depreciation and amortization.

So if you bought a property for $100,000 and you have taken $5,000 worth of depreciation, your adjusted basis is $95,000. If you sell the property for $95,000, you will have a $0 gain and will not have to pay recapture taxes on that $5,000 of depreciation.

There are many other ways to utilize tax deferred strategies to avoid depreciation recapture taxes and capital gain taxes, but can be complicated to explain and so are beyond the scope of this article. The important thing to note is that something as small as depreciation can have lasting impacts on your bottom line and is critically important to plan for in your overall investment strategy.

What has been your experience with depreciation on your properties?

Let me know with a comment.

About Author

Brandon Hall

Brandon Hall, owner of The Real Estate CPA, is an entrepreneur at heart who happens to be good at taxes. Brandon is a real estate investor and CPA specializing in providing business advice and creative tax strategies for real estate investors. Brandon's Big 4 and personal investing experiences allow him to provide unique advice to each of his clients. Sign up for my FREE NEWSLETTER to receive tips and updates related to business and taxes.

68 Comments

  1. Brandon,

    I think you have the inflation aspect backwards on this post. The dollar I kept courtesy of depreciation many years back bought much more stuff than the dollars I pay the taxes with when I sell in the future would then, so inflation increases the return on depreciation.

    As far as the die owning and screw the IRS out of the recapture and increased value option, I am actively working with older tired out landlords and negotiating master leases with them so their estates can benefit from the stepped up basis when I buy the buildings from their heirs after they pass. They also benefit from much higher earnings than they would receive from investing the proceeds of a sale post taxes and sales costs in conservative ways.

    Andy

    • Brandon Hall

      Hey Andy – I think we are arguing the same thing in terms of inflation. Maybe I wasn’t very clear in my article, but basically depreciation will yield you a fixed stream of cash flows (savings). Over time, the real value of that cash flow will decrease due to inflation, so $500 savings today is not the same as $500 savings next year.

      Interesting stuff on the master lease!

  2. Jen Shrock

    Interesting article. What stuck out most to me is the part about the heirs. While I don’t have an investment property as of yet, I am working toward that and have been thinking of setting everything up so that my great niece will inherit it some day. I have been thinking about how to set that up from the start so if you have any suggestions, I would love to hear them. She is still very much a minor (under 1), so I know that she will need an executor to act on her behalf if, heaven forbid, something would happen to me sooner rather than later. Also, when I finally make the jump, I will obviously be building my team. You ever work with clients out of state. 😀

  3. phoenix ocionna

    great article Brandon!

    so if my business makes 100k in a year and i spend 100k on an expense such as labor, then i can deduct that 100k and thus my taxable income is 0 that year.

    but if instead i buy a building for 100k then i can only deduct , using your example , $3273. so my taxable income is almost 97k and if i am in a 28% tax bracket then i must pay tax of 27k that year . therefore to buy that building i need 127k on hand that year not 100k .

    am i correct in my reasoning here?

    • Brandon Hall

      Hey Pheonix – your reasoning is correct. A capital outlay for a purchase of a building is not considered a currently deductible expense, so you would need to undergo appropriate tax planning to understand your tax liability.

      • phoenix ocionna

        thanks for confirming that Brandon,
        the key phrase is “currently deductible”.
        pretax 100k is an entirely different thing to aftertax 100k, which is why tax planning and strategy is so vital.
        its not about what you make its about what you keep….

        thanks for answering my kind of off topic question!

    • Chuck Burke

      “therefore to buy that building i need 127k on hand that year not 100k.” – no, this is not correct. The depreciation recapture comes at the sale of the property, not at the purchase. And the amount of recapture depends on how long you’ve held the property.

      • Brandon Hall

        Hey Chuck – The way Phoenix laid out his assumptions makes that statement correct, here’s why:

        If he has $100k profit and purchases a building for $100k, then annual depreciation is roughly $3k. This means his Net Income is $97k ($100k – $3k) and since he is in the 28% tax bracket, his tax liability is roughly $27k ($97 x .28). Since his capital outlay consisted of $100k to purchase the building, and he now owes $27k in taxes, he really needs $127k in his pocket prior to purchasing the building in order to cover his tax liability.

        This was a very basic example and looked solely at the affect of the capital outlay to purchase the building and annual depreciation. Depreciation recapture was not considered in this example.

        Hope that helps.

  4. Cory Binsfield

    Just a heads up, rental real estate is depreciated at 27.5 years no matter if it’s 1 or 100 units. In your example you mentioned anything over 5 units is considered commercial property.

    I guess I never looked at the recapture rate versus the personal income tax rate. In my experience the people I have consulted ended up in a higher tax bracket when they sold due to the capital gain. For example, they go from a 15% rate to a 30% or higher rate.

    One of the most compelling aspects of real estate investing (assuming you qualify as a real estate professional) is the ability to lower your tax bracket on your W-2 earnings as a result of depreciation.

    For this reason alone, I see deprecation as one of the only tools to free up more cash in the form of lower Federal and State taxes in order to acquire more properties.

    More importantly, if I wished to lower my adjusted gross income by $18,000 I could contribute the maximum to 401k. Or, I could purchase a $495,000 apartment building (excluding the land portion) and achieve the same tax deduction.

    The difference is I have to contribute 18,000 per year for the next 27.5 years versus a one time contribution to acquire the apartment building that spits out the same deduction for the next 27.5 years.

    My goal over the long term is to either 1031 to avoid the recapture or let my heirs inherit the properties tax free.

    Oh, and to continue to frow my depreciation expense!

    • Brandon Hall

      Thanks Cory and great catch on the depreciable life of an apartment building. I’m not sure why I said that (it was late when I was typing this up, but still not an excuse!) and what I should have said was “non-residential” has a depreciable life of 39 years!

      • sri ram

        Good Post.Thanks for clarifying the apartment buildings are depreciated for 27.5 years. I have been doing the same for last 12 years. I am wondering &little confused as to what my tax bracket is at the moment(which is dumb) I don’t owe any taxes because of the depreciation in my 100 unit portfolio. I have toask my accountant on that.

  5. Jerry W.

    Hey Brandon,
    Great article. On the free stepped up basis, most folks own their rentals in some form of a corporation like a Sub S or an LLC. If they die and the company sells the property, isn’t the recapture tax still applied? I would have assumed the property must be in your personal name to get the stepped up bases. At best you are talking share value of the business being passed, not the recapture on properties it owns.

    • Brandon Hall

      Hey Jerry – thanks for reading and you’ve asked a great question. So your basis in the entity is equal to the FMV of your share. So when your heir receives your shares on a stepped-up basis, they are essentially receiving a stepped up basis in the property itself. It then becomes a liquidation question.

      Ex. Your LLC owns one property with a FMV of $100k. You pass away and your heir receives a stepped-up basis of your LLC’s share at FMV, which is $100k. Your heir can then liquidate the entity and keep the stepped-up basis in the property without tax ramifications.

      Does that help?

  6. Nnabuenyi Anigbogu

    Quite an interesting article. I have been interested in depreciation recapture since early this year when my Agent gave me a pro forma for a rental property that included a page on disposition of said property. Once i saw those words and the potential cost i started doing research to find out more. Now that i own said property it definitely plays into my strategy going forward.

    I am in the market for a good real estate CPA to utilize and also learn from. I would be interested to talking to you about your business and how we might be able to work together.

    Thanks

    • Brandon Hall

      Hey Nnabuenyi – thanks for reading and commenting. Depreciation recapture should definitely play a role in your exit strategy. I’d be happy to set up a time to speak with you – feel free to connect with me and we can set something up.

  7. Michael Le

    Thanks for the article. I think a lot of people, like me, either never knew about the depreciation recapture taxes or were not in the affected tax bracket or were buy and hold investors so never gave much thought to the potential downsides. It’s a good reminder to remember there is multiple ways to approach and manage this business.

    • Brandon Hall

      Hey Michael – thanks for reading and I appreciate your comment as it is in line with a lot of what I see. People talk about how great depreciation is without factoring the recapture into their exit strategies which is something I certainly discuss with my clients. Glad you commented!

  8. Rong Li

    Great article.

    Per my understand, you can’t avoid recapture tax liability by not claiming depreciation. The IRS will charge recapture tax based on the depreciation that you could have taken, even if you didn’t take it. Right?

      • Byron Bohlsen

        This piece confuses me,

        So the fed will calculate and charge a recapture regardless if the tax benefits were used or not?… so your better off using it no matter what tax bracket your in and if your in a higher tax bracket it just happens to benefit you more so?

        • Brandon Hall

          Hey Byron – this is correct, the IRS will charge you depreciation recapture regardless of whether or not depreciation was taken. It should also be noted that depreciation is NOT an option, it is a requirement.

          If you are in a lower tax bracket, you will want to apportion as much of the purchase price to land as possible. This will decrease your improvement value an subsequently your annual depreciation. However, you must be able to support your number (you can’t just apply a random ratio) and you should consult a tax advisor prior to filing your returns to make sure this method makes sense for you.

  9. Paul Halphen

    Good article and good comments. Thanks for not being afraid of being wrong and publishing an article that gets discussion going.

    I would be curious to know if a charitable remainder trust would be another way to avoid the recapture tax. That would be yet another reason to use the trust.

    • Brandon Hall

      Hey Paul – thanks for the comment and I’ll be the first to admit when I’m wrong about something. A bit of humility never hurt anyone and I appreciate the support 🙂

      A CRT is a great way to avoid depreciation recapture, especially if you are dealing with an asset you have held for a long time or one that has appreciated substantially. Assets sold within a CRT are not subject to depreciation recapture or capital gains, and you can even pay yourself over time as long as the “charitable remainder” stays intact.

      Great question!

  10. Chuck Burke

    @Paul – I think you missed Phoenix’s second statement in the comments. He said, “therefore to buy that building i need 127k on hand that year not 100k.” and you agreed with him, but I think you were only focused on the first part of what he said.

    • Brandon Hall

      Hey Chuck – I responded to your other comment but wanted to say the same thing here as well.

      The way Phoenix laid out his assumptions makes the statement “therefore to buy that building I need 127k on hand that year not 100k” correct, here’s why:

      If he has $100k profit and purchases a building for $100k, then annual depreciation is roughly $3k. This means his Net Income is $97k ($100k – $3k) and since he is in the 28% tax bracket, his tax liability is roughly $27k ($97 x .28). Since his capital outlay consisted of $100k to purchase the building, and he now owes $27k in taxes, he really needs $127k in his pocket prior to purchasing the building in order to cover his tax liability.

      This was a very basic example and looked solely at the affect of the capital outlay to purchase the building and annual depreciation. Depreciation recapture was not considered in this example.

      Hope that helps.

  11. Bernd K.

    Hi Brandon –

    thanks for the clear article.

    One issue comes to mind: Double taxation.

    It seems as if a property owner would have to pay taxes on the amount of depreciation twice: First, the depreciation recapture tax at 25% of the amount. Second, capital gains tax when the property is sold, since the cost basis of the property is reduced by the amount of depreciation.

    Is my understanding correct?

    • Brandon Hall

      Hey Bernd – you get to deduct depreciation expenses annually which reduces your taxable income. So each year you depreciate, your benefit will be the tax savings realized from depreciation expense.

      When you sell the property, you pay depreciation recapture on the total value of depreciation taken, then any extra is capital gains.

      For example, you buy a property for $100k and determine the improvement value is $82.5k, your annual depreciation will be $3k. If you sell after ten years for $120k, you will have a gain of $50k. However, your adjusted basis in the property will be $70k, so $30k will be subject to the depreciation recapture and the remaining $20k will be subject to capital gains. Basically, there is no overlap that would cause double taxation. Your gain is just subject to two different types of taxes.

      Hope this helps!

  12. Mike Palmer

    What about house hacking–is that a 4th way? For example, you rent out part of your house and depreciate that portion. Then you sell the house taking the owner-occupied tax exemption. How does the depreciation factor in with that?

    • Brandon Hall

      Hey Mike – excellent question. The exemption you are referring to is called the Section 121 Exclusion which allows you to exclude capital gains of up to $250k ($500k if MFJ) from taxes assuming you lived in the property as your primary residence during the previous 60 months for at least 24 months.

      If you rent part of the house out, your depreciation will still be recaptured at a 25% rate upon sale. The Section 121 exclusion only applies to capital gains and does not exclude depreciation recapture.

      See Code § 121(d)(6) for more the technical version of what I just said.

  13. Gleb Molotchev

    Brandon, there are some inaccuracies in your article that may confuse investors who do not utilize the services of an accounting professional. The additional depreciation recapture on sec. 1250 property is treated as ordinary income hence will be taxed at taxpayer’s current income tax rate (see IRS publication 544). The additional depreciation is basically depreciation taken at the higher rate than the straight line depreciation. For a residential building structure (excluding the rest of the distinct building systems) the straight line depreciation is 27.5 years. If the owner utilizes a straight-line depreciation method, there is no additional depreciation. The capital gain tax if there is any will be calculated taken the purchase price of the building minus the building’s adjusted bases that takes your regular accumulated depreciation into account.
    For the readers I would suggest to utilize the services of an accounting professional who specializes in the field of real estate. The final IRS regulations on tangible property came out in 2014 and have quite specific requirements on record keeping and tangible property depreciation. Also the regulations provide a Safe Harbor for Small Taxpayers that deals with correct treatment of deductible repair expenses vs.improvements that need to be capitalized and depreciated.

    • Brandon Hall

      Hey Gleb – thanks for reading and commenting. Will you please point out the specific inaccuracies you speak of? I’d like to edit the article to ensure it is 100% correct, so if you see inaccuracies, please specifically point them out.

      I appreciate you further explaining Sec. 1250 property and Accelerated Depreciation methods. I left that out for three reasons: (1) I think it’s beyond the scope of the article and, as you said, investors who don’t utilize accounting professionals will be confused; (2) the point of the article was to make investors aware that depreciation recapture is real, and depreciation expense is not free; (3) it simply would have been too long of an article to write and if the reader want’s advanced tax planning strategies, they should connect with a professional.

      You wrote: “The capital gain tax if there is any will be calculated taken the purchase price of the building minus the building’s adjusted bases that takes your regular accumulated depreciation into account.”

      This is in-line with my writing – your total gain is your net sales price less adjusted basis. You add back in depreciation for unrecaptured sect. 1250 gain to get your new adjusted basis. The difference between the sales price and your new adjusted basis is subject to capital gains tax.

      I’ve written pretty extensively on the Final Tangible Property Regs – feel free to check out my other articles.

      • Gleb Molotchev

        Brandon, thank you for your reply. When the straight line depreciation is used (and that’s what most small investors I have encountered use), there is no additional depreciation recapture ( which would be taxed as regular income, whatever your rate is). So,if there is a gain after the sale of the real property held for over a year, capital gain tax of will be paid,15% for most taxpayers, 20% for the people in 39,6% bracket. So, I am not sure how you came up with 25%.

        • Brandon Hall

          Gleb – you will absolutely pay depreciation recapture at a 25% rate, not your ordinary income rate. either you are confusing Section 1245 and 1250 property. Or you are confusing my post about recapture taxes with additional depreciation. Throughout my post, when I refer to depreciation recapture, I am referring to Unrecaptured Sect. 1250 Gain.

          “Additional Depreciation” for 1250 property is the portion of accumulated depreciation in excess of straight line and is taxed at ordinary income tax rates. The portion of accumulated depreciation which corresponds to straight line depreciation is called “Unrecaptured Section 1250 Gain” and it is taxed at a rate of 25%.

          You need to run through an example and test it for yourself – find the “Unrecaptured Section 1250 Gain Worksheet—Line 19” and the “Schedule D Tax Worksheet” in the 1040 Schedule D instructions.

          On the “Schedule D Tax Worksheet” if you look at item #38 – “Multiply line 37 by 25% (.25)” – that’s where the recapture tax comes in to play. It’s not taxed at your ordinary tax rate. Only additional depreciation for Section 1250 is taxed at ordinary rates.

  14. Gleb Molotchev

    “When you dispose of depreciable property (section 1245 property or section 1250 property) at a gain, you may have to recognize all or part of the gain as ordinary income under the depreciation recapture rules. Any remaining gain is a section 1231 gain.”
    “Section 1250 Property

    Gain on the disposition of section 1250 property is treated as ordinary income to the extent of additional depreciation allowed or allowable on the property. ”

    “Gain Treated as Ordinary Income

    To find what part of the gain from the disposition of section 1250 property is treated as ordinary income, follow these steps.

    In a sale, exchange, or involuntary conversion of the property, figure the amount realized that is more than the adjusted basis of the property. In any other disposition of the property, figure the fair market value that is more than the adjusted basis.

    Figure the additional depreciation for the periods after 1975.

    Multiply the lesser of (1) or (2) by the applicable percentage, discussed earlier under Applicable Percentage. Stop here if this is residential rental property or if (2) is equal to or more than (1). This is the gain treated as ordinary income because of additional depreciation.

    Subtract (2) from (1).

    Figure the additional depreciation for periods after 1969 but before 1976.

    Add the lesser of (4) or (5) to the result in (3). This is the gain treated as ordinary income because of additional depreciation.”

    These are quotes from the IRS publication 544, Sales and other disposition of property, section 3, Ordinary or Capital Gain or Loss on the disposition of business property.

    “(a) General rule
    Except as otherwise provided in this section—
    (1) Additional depreciation after December 31, 1975
    (A) In general
    If section 1250 property is disposed of after December 31, 1975, then the applicable percentage of the lower of—
    (i) that portion of the additional depreciation (as defined in subsection (b)(1) or (4)) attributable to periods after December 31, 1975, in respect of the property, or
    (ii) the excess of the amount realized (in the case of a sale, exchange, or involuntary conversion), or the fair market value of such property (in the case of any other disposition), over the adjusted basis of such property,
    shall be treated as gain which is ordinary income. Such gain shall be recognized notwithstanding any other provision of this subtitle.”

    This is 26 U.S.Code Sec.1250.
    Ordinary income are the key words here. But we are splitting hairs anyway since you will not find investors who will not utilize a regular straight line depreciation. What most people have problems with is cost segregation for all the building systems and not creating proper depreciation schedules for assets that come along with the rental, i.e. refrigerators,stoves, etc.

    • Brandon Hall

      Gleb – I’m quite familiar with the code.

      Unrecaptured Section 1250 gain is the amount of the depreciation taken on the property that is not recaptured as ordinary income under Section 1250.

      Per the code you quoted:
      “Gain on the disposition of section 1250 property is treated as ordinary income to the extent of additional depreciation allowed or allowable on the property.” — Emphasis added to “additional depreciation”

      “Multiply the lesser of (1) or (2) by the applicable percentage, discussed earlier under Applicable Percentage. Stop here if this is residential rental property or if (2) is equal to or more than (1). This is the gain treated as ordinary income because of additional depreciation.” — Emphasis added to “This is the gain treated as ordinary income because of additional depreciation”

      As you can see, ordinary income rates only apply to additional depreciation in excess of straight line. The regular recapture will be taxed at 25%.

      Again, go through those worksheets in the Schedule D instructions.

    • Brandon Hall

      Whew THANK YOU! Haha – I seriously thought I was going nuts over here.

      On another note, let’s please connect and maybe chat on the phone. I learned a lot tonight just through my trying to 100% research all of this and I’d love to continue discussing various tax aspects with you in the future.

      Cheers!

  15. I think the rule is you can rent out a residential or business portion of your residence to up to two parties and you must declare the income but you do not need to convert the square footage of the rentals to rental property and depreciate it. Is that correct?

    • Brandon Hall

      Looking at the property tax card is one way to do it. If the property tax card shows land value of $20k and improvement value of $80k, your improvement ratio is 80% (80/(20+80)). You then apply that ratio to your purchase price to get your improvement value.

      You will not change your depreciation calculations unless you elect to change your method of accounting by filing form 3115.

  16. Daniel Ryu

    Hey Brandon!

    How’s it going? I was just working with another investor, modeling scenarios about what he should do with his property (Keep or Sell and buy more) and depreciation recapture came up as I was looking at how future cashflows would be affected.

    Anyways, this is great stuff! I can see why you’ve been busy – putting out awesome content like this must take a lot of time ^^

    I’ve been busy too launching our group’s website and working on Mobile Home Park Investing opportunities, but I look forward to getting back in touch with you in the future!

    Maybe we can talk about that book idea again ^^

    Take care!

  17. jim morisseau on

    Hi- can you help? I got stuck in 2008, I bought a second vacation/retirement home using my first home for the mortgage, then lost my job and moved into the smaller second home and rented the first one to avoid foreclosure., knew nothing about taxes. So I have basically only broken even on the rent, my own taxable income ranges from zero to a few thousand, and the home I rent is worth less today than when I started renting it, I never did any depreciation and now I will get screwed if I sell it? How can this be?

  18. Dear Brandon,

    Thank you for the excellent article. Though I am reading it 14 months after you published it in Aug 2015, your reference to how this 25% tax depreciation recapture tax comes through on Schedule D line 19 (Unrecaptured Section 1250 Gain) and from line 37 of the Schedule D Tax Worksheet is very useful.

    I have a question relating to this depreciation recapture tax. I studied these two lines in schedule D a little bit to understand the implication behind them. It seems like we only have to fill out this line 19 in Schedule D when line 16 and 17 on Schedule D are both positive, meaning the short-term capital gain and long-term capital gain are both positive. So what if I have a long-term capital gain from selling the rental property, but I also have lot of short-term capital loss (such as from stock investment loss carryover from prior years) that is big enough to cover the entire long-term capital gain such that my net capital gain is still negative for the current year? According to the instruction on line 16 which asks us to add short-term and long-term gain, it will show a negative number for line 16 and thus skip filling out line 19, Unrecaptured Section 1250 Gain.

    Is this correct? If I have a large short-term capital loss carryover from prior years, then any long-term capital gain from selling the rental property along with its unrecaptured depreciated can be offset by this capital loss, up to the amount of my short-term capital loss carryover?

    If this is true, this will be wonderful as I surely do not know how to totally use up this large capital loss carryover from the 2008-2010 stock decline. $3000/year deduction is simply too little. $100K on stock loss will require 33 years to fully write it off. If what I think is true, then I would not need to use 1031 exchange just to avoid paying capital gain tax and depreciation recapture tax from the gains of selling my rental property?

    Thank you very much in advance for your opinion.

    Thank you very much.

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