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.
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.
There is no law that states that you have to depreciate your rental property. This is a tax advantage to lower the income tax you pay on the rental income. If you do not take the standard depreciation, then you just pay more income tax each year.
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.
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.
Depreciation is a tax strategy which allows you to realize the expense of the property and use those expense to offset income from the property, thus reducing the owner's tax liability. However, when you sell a property, you have to recapture the depreciation that was previously taken as a tax benefit.
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.
The downside of depreciation is depreciation recapture, which rears its claws upon sale of a depreciated asset. Depreciation recapture is the portion of your gain attributable to the depreciation you took on your property during prior years of ownership, also known as accumulated depreciation.
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.
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.
If those fees cost you $300, you'd subtract that from the sale price. This value would be your net proceeds. You'd then subtract $12,000 from that value to earn a realized gain of $1,500. However, if there was a loss at the point of the depreciated asset's sale, you wouldn't be able to recapture a depreciation.
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).
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.
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.
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.
The most effective way to use capital losses is to deduct them from your ordinary income. You almost certainly pay a higher tax rate on ordinary income than on long-term capital gains so it makes more sense to deduct those losses against it.
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.
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.
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.
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.
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.
Planning for Depreciation Recapture
While there are limited ways to get around paying depreciation recapture taxes on gains from the sale of qualifying properties, many rental property owners may be able to deduct passive activity losses, which can offset the cost of depreciation recapture.