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%.
Depreciation Recapture
Owning a rental property means you can take a specific tax deduction for asset depreciation every year. However, you'll owe the deducted amount if you sell the property after turning it into your primary residence. This aspect can erode the Section 121 exclusion you receive when selling.
You can't claim depreciation on property held for personal purposes. If you use property, such as a car, for both business or investment and personal purposes, you can depreciate only the business or investment use portion. Land is never depreciable, although buildings and certain land improvements may be.
The short answer is that depreciation on a rental property doesn't need to be paid back in a literal sense. Because depreciation is considered a non-cash expense, it doesn't involve any actual expenses out-of-pocket.
When you sell a depreciated capital asset, you may be able to earn a “realized gain” if the asset's sale price is higher than its value after deduction expenses. You'll then be able to recapture the difference between the two figures after you report it as income.
Other landlords worry that claiming depreciation could result in lower income from their property, reducing their cash flow. However, depreciation isn't an actual cash expense; it's simply a tax deduction. In other words, depreciation may lower your taxable income, but it doesn't affect your cash flow.
If you like your rental property enough to live in it, you could convert it to a primary residence to avoid capital gains tax. There are some rules, however, that the IRS enforces. You have to own the home for at least five years. And you have to live in it for at least two out of five years before you sell it.
The 121 exclusion allows homeowners to exclude capital gains but not depreciation recapture from their taxable income when they sell their primary residence that was also held as an investment property.
Depreciation recapture is the gain realized by selling depreciable capital property reported as ordinary income for tax purposes. It is assessed when an asset's sale price exceeds the tax or adjusted cost basis.
If a property is inherited, the basis for the property is stepped up to its fair market value at the date of the decedent's death, potentially reducing the depreciation recapture when the heir sells the property.
Since most depreciable real property is depreciated under the straight-line method, true section 1250 recapture generally does not apply. Some circumstances where it may apply is where accelerated and/or bonus depreciation property is taken on real property such as land improvements or qualified improvement property.
Once you occupy the home as your personal residence, you will no longer be able to take any of the deductions you took when the property was a rental. This means you will get no depreciation deduction and you can't deduct the cost of repairs.
Section 121 of the Internal Revenue Code allows you to reduce or eliminate capital gains tax by converting your rental property to your primary residence before selling if: You own the home for at least 2 of the preceding 5 years before selling it.
U.S. Postal Service address, Voter Registration Card, Federal and state tax returns, and. Driver's license or car registration.
Moving back into your rental to claim the primary residence gain exclusion does not allow you to exclude your depreciation recapture, so you might still owe a hefty tax bill after moving back, depending on how much depreciation was deducted (IRS, 2023).
A few options to legally avoid paying capital gains tax on investment property include buying your property with a retirement account, converting the property from an investment property to a primary residence, utilizing tax harvesting, and using Section 1031 of the IRS code for deferring taxes.
The second method investors can use to defer depreciation recapture is to complete a 1031 or like-kind exchange. If you swap one investment property for another and roll the entirety of sales proceeds into the new asset, you can defer both depreciation recapture and capital gains taxes.
You will owe 25 percent of what you could have deducted as a “depreciation recapture” when you sell the property. That amount is due whether you take a deduction or not.
Depreciation Recapture tax is 25% across the board, only second to real estate owned less than one year, taxed as ordinary income which could be as high as 37%.
Depreciation recapture occurs when you sell business property for a gain after taking depreciation deductions. This tax rule requires you to report part of your gain as ordinary income to “recapture” some of the benefit you previously received from the deductions.
Investors can defer depreciation recapture by engaging in a 1031 property exchange, also called a like kind exchange. The specific rules of a 1031 Exchange are outlined in section 1031 of the internal revenue code, but they can be complex.
By convention, most U.S. residential rental property is typically depreciated at a rate of 3.636% each year for 27.5 years.