Investment property recapture refers to the process of the IRS taking back all or part of the depreciation deductions you claimed on your rental property over the years when you sell it at a profit. This can result in owing significant capital gains taxes. As an investment property owner, it’s crucial to understand recapture rules and utilize strategies to minimize your tax liability. This article will provide an in-depth look at recapture, including how it works, scenarios when it applies, and legal ways to reduce your recapture taxes through cost segregation, 1031 exchanges, installment sales, etc. With proper planning, real estate investors can continue benefiting from valuable depreciation deductions without facing huge recapture taxes down the road.
Understanding depreciation recapture on investment property
When you own rental property, the IRS allows you to deduct a portion of your property value as depreciation each year on your taxes, as the property theoretically declines in value over its useful lifespan. This reduces your taxable rental income. However, when you sell the property at a profit later on, the IRS may ‘recapture’ all or part of the depreciation you previously deducted. For example, if you deducted $100,000 in depreciation over the years and sold the property for $50,000 more than your purchase price, you’d owe recapture taxes on $50,000 of the deductions. Recapture is taxed at capital gains rates, up to 25%, rather than lower ordinary income rates. As such, it can result in thousands extra in taxes and eliminate much of the tax benefits of investing in real estate.
When recapture applies on investment property sales
You will owe depreciation recapture taxes any time you sell investment property for more than your adjusted cost basis. Your original purchase price is adjusted higher by capital improvements and lower by cumulative depreciation taken. If your sales price exceeds this adjusted basis, the difference is taxable capital gain. Any gain up to the amount of past depreciation deductions will be subject to recapture. However, you can defer or avoid recapture taxes in certain cases, such as conducting a 1031 exchange into a new investment property or passing the property to heirs with a stepped-up cost basis.
Utilizing cost segregation to minimize investment property recapture
Cost segregation is an effective tax strategy to reduce future depreciation recapture liability. It involves working with an engineer to separate tangible personal property with shorter lifespans from real property on a new rental acquisition. The personal property components get accelerated depreciation over 5 or 7 years, while real property is depreciated over 27.5 or 39 years. This increases your depreciation deductions in the early years, while reducing tax basis later on. Segregating just 20% of a property’s value into 5-year property could save over $50,000 in recapture taxes on a $1 million building. The upfront engineering costs are far outweighed by the tax savings. Performing a cost segregation study can be well worth it to minimize recapture exposure when selling.
Utilizing 1031 exchanges to defer investment property recapture taxes
A 1031 exchange allows you to defer capital gains taxes, including recapture, when selling one investment property and acquiring another of equal or greater value within 180 days. By rolling over your proceeds into a new rental property, you can continue deferring accumulated recapture taxes until you eventually sell your last property. 1031 exchanges must be carefully executed, with the help of a qualified intermediary, to avoid violating IRS rules. But they remain one of the best tools to build a real estate portfolio while deferring taxes. Just be sure to consult with both your CPA and 1031 intermediary to ensure you handle everything correctly.
As an investment property owner, being aware of depreciation recapture rules and tax minimization strategies allows you to maximize after-tax returns on your real estate investments. Consult with tax professionals to project your future recapture liability. Then utilize cost segregation, 1031 exchanges, installment sales, and other techniques to legally minimize the inevitable recapture taxes when you eventually sell for a profit.