You can't fully avoid depreciation recapture when selling a depreciated asset for a gain, but you can defer or eliminate the tax through strategies like a 1031 Exchange (deferring by reinvesting in a like-kind property), passing the property to heirs (who get a stepped-up basis, wiping out the recapture), selling at a loss, or using installment sales, with the core idea being to defer the "bill" indefinitely or until death.
Depreciation recapture is an unavoidable tax consequence that occurs when a depreciated asset is sold for a gain.
If you don't claim your depreciation deduction, you pay the total penalty upon the sale of the property but still forfeit any tax benefits while you own it. It's best to claim the deduction each year and plan accordingly, which can involve paying the total recapture tax or finding strategies to avoid it.
Best Paid & Free Alternatives to Recapture
You might be able to minimize the tax hit from depreciation recapture. Potential strategies include purchasing replacement property in a Section 1031 exchange, timing the sale of business property to when you're in a lower tax bracket, and investing in a Qualified Opportunity Fund.
When you sell a fully depreciated asset, the gain from the sale may be subject to depreciation recapture tax. Depreciation recapture is the process of taxing the portion of the gain that corresponds to the depreciation deductions you've previously claimed.
Only depreciation claimed in excess of straight-line depreciation is recaptured as ordinary income. For most modern buildings, this is often zero, but any remaining gain attributable to straight-line depreciation may be taxed at a special 25% rate.
So, instead of eliminating the tax liability, skipping depreciation may actually increase your overall tax liability. By not reporting depreciation, you're missing out on a significant tax deduction each year and may eventually end up paying recapture tax on a deduction you never claimed.
In summary, the three triggers of recapture are disposition, noncompliance and casualty loss.
Depreciation is a valuable method of reducing your tax obligation each year so that the purchase cost of your investment property can be spread out over decades. Just be aware that if you sell your property for more than the depreciated value, you will need to pay depreciation recapture tax for the gain.
If you don't claim some or all of the depreciation deductions allowable under the law, you must still reduce the basis of the property by the amount allowable before determining your gain on the sale of the property.
Key Takeaways
Depreciation expense taken by a real estate investor is recaptured when the property is sold. Depreciation recapture is taxed at an investor's ordinary income tax rate, up to a maximum of 25%. Remaining profits from the sale of a rental property are taxed at the capital gains tax rate of 0%, 15%, or 20%.
Assets that are fully depreciated (i.e., the net book value of the historical cost less accumulated depreciation is zero) and that are no longer in use must be written off.
Depreciation recapture is deferred – along with capital gain – if all of the below occur: The Exchanger acquires Replacement Property equal or greater in value to the Relinquished Property. All exchange proceeds are reinvested in qualifying real estate. Debt is replaced with new debt or additional cash investment.
Knowledgeable taxpayers know depreciation recapture isn't always bad. Sometimes the net present value of tax savings exceeds the recapture tax. The recapture doesn't entirely cancel out benefits realized during the depreciation period.
(7) Recapture period For purposes of this subsection, the term “recapture period” means the 15 taxable years beginning with the second taxable year following the taxable year in which the purchase of the principal residence for which a credit is allowed under subsection (a) was made.
Example 1: capture recapture
He sets up a trap and collects 36 woodlice over one night. He marks them using UV paint, and then releases them back into his garden. One week later, he repeats the experiment by placing the same trap in the same location to collect the woodlice over the same time frame.