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.
Moving Back In to Save on Taxes
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).
Fortunately, the 1031 Exchange defers the recapture as well as your capital gain liabilities. For additional information, please reach out to your tax professional for specific questions or contact the specialists here at Security 1st Exchange for assistance.
Sections 1245 and 1250 were enacted to close the loophole that resulted from allowing depreciation deductions on assets to offset ordinary income while taxing gain from the sale of these depreciated assets as capital gains.
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.
Under section 121 of the Internal Revenue Code, you may be able to exclude much of the gain from the sale of your main home that you also used for business or to produce rental income, if you meet the ownership and use tests.
While a primary residence qualifies for a gain exclusion of $500,000 (or $250,000 if single), the depreciation recapture tax liability does not get wiped out.
Utilizing a Deferred Sales Trust, investors can defer capital gains taxes over time. Deferred Sales Trusts provide an alternative to 1031 exchanges for deferring capital gains taxes on appreciated assets.
If the investor's property has been depreciated over many years, the additional depreciation — the part subject to “recapture” — may be relatively small. As a result, a significant portion of the gain due to depreciation may be treated as a long-term capital gain that can be offset with capital losses.
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.
Depreciation is a valuable deduction for rental property owners since it helps offset natural wear and tear or damages that happen over time. However, if you plan on selling the property, depreciation that's been taken out must be recaptured and paid back to the government.
To avoid recapture of depreciation deductions on the home office, taxpayers do not claim depreciation. The depreciation allowed is the amount you claimed on your tax return. The depreciation allowable is the amount you should have claimed on your tax return.
How Can Individuals Avoid Depreciation Recapture? Depreciation recapture can be costly when selling something like real estate. Other than selling the property for less, which isn't a favorable option, ways around it could include using the IRS Section 121 exclusion or passing the property to your heirs.
Sale of your principal residence. We conform to the IRS rules and allow you to exclude, up to a certain amount, the gain you make on the sale of your home. You may take an exclusion if you owned and used the home for at least 2 out of 5 years. In addition, you may only have one home at a time.
Some investors may be tempted to skip claiming depreciation to avoid the risk of depreciation recapture tax, but this generally won't succeed. The IRS assumes that you have taken a depreciation deduction. You will owe 25 percent of what you could have deducted as a “depreciation recapture” when you sell the property.
This temporary difference in depreciation expense is called deferred depreciation. Deferred depreciation occurs when you use different depreciation methods in the corporate and tax books. The depreciation calculation reduces, and eventually eliminates, the temporary difference as the asset becomes fully reserved.
Here's how it works: Taxpayers can claim a full capital gains tax exemption for their principal place of residence (PPOR). They also can claim this exemption for up to six years if they move out of their PPOR and then rent it out. There are some qualifying conditions for leaving your principal place of residence.
Use a 1031 Exchange to Defer Capital Gains
A 1031 exchange is essentially swapping one real estate investment for another. It's a popular way to defer capital gains taxes when selling a rental home or even a business.
The tax rate for the depreciation recapture is contingent upon whether an asset is a section 1245 or 1250 asset. When section 1250 property is sold, gain up to the amount of depreciation claimed is generally taxed at a maximum rate of 25 percent.
1031 Exchanges allow you to defer both the capital gains tax and depreciation recapture from the sale of a property and invest the proceeds into another “like-kind” property, often called “trading up.”
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.
For example, if you lived in the property for 50% of the time and rented it out for the other 50% of the time, you may be able to exclude up to 50% of the capital gain. Rental Property: If you sell a rental property, you don't qualify for the Section 121 exclusion.
Capital gains tax rates
Net capital gains are taxed at different rates depending on overall taxable income, although some or all net capital gain may be taxed at 0%. For taxable years beginning in 2024, the tax rate on most net capital gain is no higher than 15% for most individuals.