Depreciation is an accounting method that allows property owners to deduct the cost of an asset over its useful life. In real estate, it's used to allocate the cost of a building (excluding land) over a set number of years, typically 27.5 years for residential property and 39 years for commercial property. This annual depreciation expense reduces the property owner's taxable income, which in turn reduces the amount of income tax they owe each year.
Here's how it works:
Now, let's get to the concept of Depreciation Recapture:
Depreciation recapture comes into play when you sell a property on which you've claimed depreciation deductions. Here's how it works:
https://www.youtube.com/watch?v=YaGutYbwBE8
Strategy 1: Depreciation and Recapture
Strategy 2: 121 Exclusion
Strategy 3: 1031 Exchange
Throughout the video, Toby encourages viewers to explore these strategies as legitimate ways to minimize or eliminate capital gains taxes legally. He also invites them to subscribe to his channel for more valuable tax-related content and welcomes suggestions for future topics. This comprehensive summary captures the key points discussed in the video, providing a clear understanding of these tax-saving strategies in real estate transactions.
Hey, guys. Toby Mathis here. And today, we're going to go over a pretty interesting topic, which is how to pay 0% on capital gains when you sell a property. It's going to surprise some of you. But there are actually three ways, three ways where you can just avoid paying any sort of tax on this. There are two of them that are permanent. One of them that's going to require some elbow grease in the future. But let me go over these, and then specifically, I'm going to talk about real estate.
So when I'm selling real estate and I don't want to pay any capital gains on it, we're not talking about recapture. We're not talking about some of these other secondary items, although it is possible to push those out too. I'm going to specifically talk about capital gains and on a couple of different types of properties. So let's dive in.
Number one, when you own an investment property, you have the right to do what's called depreciation. Here's the funny thing is you may take depreciation, but you must recapture it when you sell. And this is not considered capital gain income. It's part of the gain, but it is recaptured on recaptured depreciation. And so what we're grabbing here is I took a deduction. Let's say that you bought a property. Let's say it's a single-family home for $200,000 and your land is $50,000. So you have $150,000 of depreciable basis for the structure, and you're going to write that off over 27 and a half years. Or if you do a cost seg, you'll be five, seven, 15, and 27 and a half years of, you know, what that is? The point is, is that you're taking a deduction as you go along because that property is going to have to be replaced every 27 and a half years. Right. Like the IRS says, it has a useful life, and you get to take a deduction over it. So that's depreciation.
The IRS says you can write that off, and you can use that to offset any rents that you bring in, for example. So we see this a lot of times when people have an investment property, and they might use it as a vacation home periodically, and they'll just be like, I'm not going to write it off. Well, here's the problem you MUST recapture. So if you haven't been taking depreciation under those circumstances, you can be in for a nasty surprise.
But that is not considered capital gains. What we're really looking at on capital gains is you think of selling your house, right? I wasn't using it as an investment property. I don't have any recapture. It's the difference between my basis and what I sell it for. You can adjust that basis by adding improvements and things like that, but at the end of the day, I'm going to be paying something called capital gains, most likely long-term capital gains on that income. And here are two options when you're doing that, when you sell your house.
Number one is you have something called a 121 exclusion, which allows you to write off up to $250,000 of capital gains if you're single or $500,000 of capital gains if you're married. So it's this kind of cool thing where, hey, I can own a house or say I bought a house for $200,000 and I'm living in it with my wife. And ten years later, we sell it for $400,000. We or two years could the last two years have been so crazy, but let's just say that's typical, and it's gone up in value there's $200,000 of gain when I sell, you know, subtract off some of the costs and things like that. Maybe I have improvements that I put on the house. But let's just say for the sake of argument that we're talking about $200,000 of capital gains. I would pay zero tax on that ever. No recapture, no worrying about, hey, do I have to invest in another property or anything? No, that's just a stone-cold. You don't have to pay any tax on it on your capital gains on that property because there's an exclusion.
And that exclusion says, I lived in it as my primary residence for two of the last five years. So 24 of the last 60 months I lived in it as my primary residence. It's in my name. It's my house, and voila, I magically get this big old exclusion that's called a 121 exclusion. And people are very aware of it nowadays because the real estate agents are, hey, we've seen appreciation in real property like crazy. And so they all have to be pretty much up on this. Otherwise, their clients are going to be impossibly surprised to pay tax on something that they wouldn't. Almost all accountants know that this is out there. It's not a hidden code provision. But you will still want to make sure that you're taking it. And so, hey, I never have to pay tax on that. It doesn't matter whether I go buy another property; it just means I never have to pay tax on it. The other way you never have to pay tax on it is, let's say, a similar situation except instead of a whole bunch of gain. Maybe I'm a retiree, and I sell my house. I bought it for $200,000, and after years of doing some improvements and things like that on the property, let's just say that I have $50,000 gain, and I'm a retiree and a husband and wife, and they're making $40,000 a year. That $50,000 on top of it is going to more than likely be taxed at zero because the long-term capital gains rates have a 0% category, up to about 90 grand. You have to look at your tax rates every year, and you look at it and you say, all right, there's my long-term capital gains rates in my falling. Below that, you get your standard deduction, everything else, and you look at it going, wait a second, I am in the 0% long-term capital gains bracket. I do not have to pay any tax on it. You'll never have to pay a tax on that. And that's fantastic. So that is way number two. So we had the 121 exclusion, and we have, hey, if it's low enough, it's going to be taxed at zero anyway.
And I get into arguments with accountants all day long on this stuff year after year because I look at people, and they might be making 30, 40, 50, $60,000 a year, and they have unrealized long-term gains in the stock market. And I'm yelling at them, sell that. Get up to the point where it's still 0% tax bracket, you know, so maybe sell $20,000 of your stock and reset the basis and buy it right back. And their accountants lose their minds and they say something like the wash sale rule. And I'm like, No, that's the wash sale loss rule. You can do this on gain, and there's no reason not to. It's recognizing gain when your taxes zero or let's say that you have a business, let's say that we're in a a bad year and in a business where you're kicking down ordinary loss or you love investing in oil and gas and you get your income down to the nub, you could sell property and have capital gains and not pay any tax on it. And a lot of times people don't realize that if you're one of those people that gets yourself down to the 0% tax bracket, I'm just telling you, it's okay to have $90,000 around $90,000 where the long-term capital gains, if you're married, cut that in half. If you're single. But you could have that, and you're going to pay a 0% tax on it.
So, yes, you could have income and still be at zero if it's capital gains.
And by the way, things like dividends on qualified companies, qualified dividends, they are also taxed as long-term capital gains. So they're at zero. So I always look at those folks are, my gosh, bless it. Like there's there's so much cool stuff here. There's a 0% bracket, and you'll never have to worry about doing anything. You don't have to reinvest it. You don't have to do anything. You just get free money. It's non-tax money. So you have 0% capital gains on your real estate. You never have to worry about it ever again.
Now, the third way is the most common one that you hear about, and that's by buying more real estate. It's called a 1031 exchange, and it's only real estate. Now, can we do this with there's no other types of assets, but if you sell an investment property and you buy more investment property and there are some rules on this, there's a time frame, 180 days, you have to identify replacement properties. You can you can do multiple properties, but not more than 200% of the value of the house of you letting go. Like, there's there's there's some rules that you have to follow. But here's the gist. You don't have to pay tax on it. You don't have to pay tax on the capital gains, nor do you have to pay tax on the recapture slows to two things are actually pretty big.
So you know go back to the situation where you have a primary residence that you lived in two of the last five years. But let's say that you rented it for one year before you sold it. Well, now you're going to have depreciation, recapture if you want to avoid it, you're going to have to actually marry the 121 with the 1031 exchange, which you can do.
The IRS tells us exactly how to do it, steps up the basis for that capital gain exclusion, and then you can offset and avoid having recapture on the depreciation, which might be a good idea, especially if you did a cost seg and you used it to offset other other passive income on something else if you're doing investments. But it's a fantastic tool to avoid the payment of tax.
So that 1031 exchange becomes your friend if you're a real estate investor. And all I have to do is keep buying more real estate of equal or greater value. I can't have, but I can't get a bunch of cash when I buy these properties. So I can't just go out and create a situation where I'm walking over the bunch of cash and not pay tax on it. I'm investing the money and I'm putting it into real estate and I'm going to continue to buy more real estate. And the really cool part here is that at the end of the day, as long as you do not sell in a taxable transaction, any of those properties. So as long as you're always 1031, eventually you pass away, your basis on those property steps up to the fair market value. On the day that you passed away, what does that mean? It means that for tax purposes, your basis is now the fair market value of the day that you passed, which means if you're heirs sell it, they pay no tax because it's that same value.
So what happened to all the capital gains and the depreciation you've been rolling forward? So a you know, 30 years ago I bought my first property at $200,000 and it went up to four. I bought a couple more. Those went up to $300,000 each. I sold those and bought five properties. Those went up to $400,000 each. And I had a $2 million portfolio. I sold those and bought some more. And now I have this portfolio of two and a half million dollars and I've never paid tax in any of the game.
And all I do is I pass away. And now if my heirs sell that two and a half million dollars for the property, you know what? My taxes or their taxes? Zero, right? I've never had to pay tax on that. So I just showed you three ways that you could never pay capital gains on real estate. I know there's tons of other cool things that the tax code gives us, but those are the three big main ones that I wanted to point out. And if you're catching that bug and realizing, wait a second, there's lots of cool stuff in the tax code, I want to learn more. Don't worry, I got you covered just like it. Subscribe this channel. I'm always putting out content like this, and if you think that this would benefit anybody else, by all means share it. And then, even more importantly, if you want me to cover other topics, put them down in the in the comments, I'll read them. And if it looks cool, I'll cut a video on whatever the topic is you are. You designate. Thanks, guys.
In this article, we discuss depreciation recapture tax, what it is, how it will affect the sale of your rental, and how to avoid it.
If you’re an experienced rental property owner who benefited from depreciation, be aware that the IRS might want some of that money back when you sell. Depreciation is one of the most significant and most advantageous deductions for real estate investors because it reduces taxable income but doesn’t reduce your cash flow—a magical tax deduction. The IRS allows real estate investors to depreciate their investment property over a period of time, 27.5 years for residential rental investments saving landlord thousands of dollars in taxes every year.
This is the part of the article where we tell you that we are not professional accountants, CPAs, or attorneys. Any information that you garner from this article should be discussed with your accountant or other professionals.
As an investment real estate owner, you and your accountant have likely become very familiar with this deduction. The IRS allows this tax deduction because, in theory, improvements have a useful life span and lose value over time. Take for example, an automobile. The IRS allows a business to depreciate an automobile over seven years. When the company trades that vehicle back into the dealer in three years, it has lost over half of the original value. If the owner has depreciated 40% of the cost on the prior year’s tax returns, they write off the final 10% when they trade it in. Thus, depreciation makes sense in such a case. However, real estate often (in fact, almost always) increases in value.
IRS tax code allows investors to depreciate the improvements (buildings, etc.) related to real estate. However, if you sell your real estate investment after 20 years and the property has increased in value, the IRS wants their money back and will assess you at a 25% tax rate on the amount you have previously deducted. For many investors who hold their real estate for an extended period, the depreciation recapture tax can be much more onerous than the capital gains tax (15%–20%).
At some point, you may decide to sell your rental property. Depreciation will play a role in the amount of taxes you’ll owe when you sell. Because depreciation expenses lower your cost basis in the property, they ultimately determine your gain or loss when you sell. The IRS will demand that you pay a premium on that portion of your gain.
If you hold the property for at least a year and sell it for a profit, you’ll pay long-term capital gains taxes. If you’re a higher-income taxpayer, you may also be on the hook for a 3.8% net investment income tax – NIIT. Additionally, you will likely encounter the devil of all taxes–depreciation recapture.
The IRS remembers all those depreciation deductions, and they’ll want some of that money back. That’s what depreciation recapture does. The rate is based on your ordinary income tax rate and is capped at 25%. It applies to the portion of the gain attributable to the depreciation deductions you’ve already taken. Because the sale of your property likely pushes you into a higher tax bracket for the year of the transaction, it is almost always 25%.
Let’s say you purchased a rental property ten years ago for $150,000. You should have written off about $54,540 in depreciation deductions over those ten years. Your adjusted cost basis in this property after the ten years is $95,460 (the original cost basis of $150,000 minus $54,540). If you can sell the property for $280,000, you will recognize a gain of $184,540 ($280,000 minus $95,460).
While it would be nice to pay taxes at the lower capital gains rate on the entire gain, you’ll pay up to 25% on the part that is tied to depreciation deductions. If you owe the maximum, it would be 25% of $54,540, or $13,635.
The remaining $130,000 is taxed at your regular long-term capital gains tax rate. Assuming you’re in the top bracket, that would be $26,000 in capital gains taxes. With just these two taxes, you’re looking at $39,635 in taxes. Also, you may owe the NIIT, and your state will likely want a piece of the action as well.
Depreciation recapture can be the most painful “stupid tax” known to humankind. Tax code requires that the IRS assumes you took the depreciation, even if you did not take the deduction. Therefore, if you have been doing your taxes for years and have not been taking advantage of depreciation when you sell your property, the IRS will assume that you have taken the deduction. They will then assess the tax on what you should have taken – even if you never benefited from the deduction.
If you own investment real estate and are looking to sell, you’ll want to become very familiar with the pending tax liability and potential strategies to defer these taxes. Many investors consider taking advantage of Section 1031 of the IRS tax code. Commonly referred to as a 1031 exchange, this section allows investors to defer paying taxes when they sell investment real estate and reinvest the proceeds from the sale in investment real estate of equal or greater value. Taxes that need to be paid on depreciation recapture, federal capital gains, state taxes, and NIIT are all deferred. Effective use of a 1031 strategy allows investors to create, store, and transfer wealth tax-free. It would be best if you planned in advance to take advantage of this deferment strategy. You should always contact a 1031 exchange specialist (qualified intermediary) before selling your current property.
Millcreek Commercial specializes in 1031 exchange strategies. Exchanging residential rental properties for other rental properties is often a net-zero trade–one set of headaches for another. However, exchanging residential rental properties for high quality, NNN leased commercial real estate can bring the safety, security, and stability your portfolio deserves. Many investors fill the role of landlord. With that title comes several things that contribute to headaches–tenants moving in and out, fixing toilets, painting walls, replacing carpet, and the list goes on. By exchanging into NNN leased commercial real estate, maintenance, improvements, and property taxes, all headaches are essentially the tenants’ responsibility. This powerful lease structure creates a true form of passive income. Learn more about how 1031 exchanges and NNN lease properties can be your “x-factor” for retirement in this blog post.
If you are looking to sell a property in the future and are interested in deferring taxes and creating passive income, please give us a call. Our investment team would love to speak with you. 385.233.9063
Want to learn more about 1031 exchanges and the benefits, rules, and risks? Download our FREE ebook — a comprehensive guide to 1031 exchanges.
What accountants need to know about rental property tax depreciation: https://tax.thomsonreuters.com/blog/what-accountants-need-to-know-about-rental-property-tax-depreciation/
Owning rental property can be an attractive real estate investment for many given the ability to collect rent and profit from the future, long-term sale of the property. There are also tax benefits to be gained.
Given such benefits, many people own rental property. Most likely, some of your clients are among them. In fact, IRS data revealed that roughly 10.6 million American tax filers declared rental income in 2019.
As a tax professional, your clients depend on your expertise to help them navigate the tax-related complexities to ensure compliance and minimize their tax obligations. This includes better understanding rental property tax depreciation.
Tax depreciation on rental property enables the property owner to recoup some of the cost of income-producing property through yearly tax deductions. This is done by depreciating the property or, in other words, deducting some of the cost each year on a taxpayer’s tax return.
This can prove to be a significant benefit to your client as it can reduce their tax liability and help them save money each year on taxes.
Depreciation begins when the rental property is put into service to produce income. Depreciation stops either when the client has fully recovered their cost or other basis, or when the property is no longer being used to generate income — whichever happens first.
As outlined by the IRS, the following requirements must be met to depreciate rental property:
It is important to note that some property, such as land and certain excepted property, cannot be depreciated.
To further explain rental property tax depreciation, consider the following example:
Your client buys an investment duplex for $400,000. You can calculate the depreciation by deducting the value of the land and dividing the remainder by 27.5 years to reach a figure for annual depreciation. Let’s assume the value of the land is $100,000. In this case, the calculation would be:
In general, investment property placed into service after 1986 is depreciated using the MACRS depreciation system.
MACRS consists of two systems that determine how to depreciate property — the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). The GDS system must be used, unless it is specifically required by law to use ADS or if ADS is elected to be used. If ADS is elected to be used, it can never be revoked.
Therefore, another step involves determining which of the two MACRS systems to apply — GDS or ADS. But again, in most cases the GDS system will be used.
Under GDS, residential rental property (buildings or structures) and structural components (such as furnaces, water pipes, venting, etc.) are depreciated over 27.5 years.
There may come a time when your client decides to sell their rental property. When that situation occurs, the IRS will look to recoup some of those depreciation deductions.
When selling rental property, clients will face a capital gains tax (the rate depends on their taxable income and filing status), and a depreciation recapture tax rate that is capped at 25%. Clients with a higher income may also be subject to net investment income tax (NIIT).
Let’s take a closer look at depreciation recapture. This is a tax that the IRS collects to “recapture” what it considers to be lost taxable income, assuming the property has been sold at a profit.
After selling the property, this extra income will be taxed on the following year’s tax return.
Consider the following example:
Ten years ago, your client bought a rental property for $200,000. Over those 10 years, the client has written off roughly $54,540 in depreciation deductions. The adjusted cost basis in this property after the 10 years is $95,460 (the original cost basis of $150,000 minus $54,540) (Steven: I’m guessing land was like $50k or something?). If the client sells the property for $280,000, they will recognize a gain of $184,540 ($280,000 minus $95,460).
The client will then pay up to 25% on the portion that is tied to depreciation deductions. So, this would be 25% of $54,540, or $13,635.
The remaining $130,000 is hit with a capital gains tax. And, if the client has a higher income, they may also owe NIIT.
There is a way to avoid depreciation recapture tax. If your client sells the rental property and wants to reinvest the proceeds from the sale into another investment real estate that is of equal or greater value, they may be able to take advantage of a 1031 exchange.
This strategy would enable the client to defer paying taxes (i.e., depreciation recapture, capital gains, state taxes, and, if applicable, NIIT) when they sell their rental property.
Efficiently managing rental property depreciation means having the right technology solutions in place.
Leveraging comprehensive depreciation software such as Thomson Reuters Fixed Assets CS® enables practitioners to work smarter and faster with unlimited depreciation treatments, automatic federal and state depreciation calculations, customized reporting, and more.
Turn to Thomson Reuters to get expert guidance on tax depreciation and other cost recovery issues to help your firm better serve clients with rental properties.