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.
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.
The short-term rental tax loophole allows for the favorable tax treatment of income from short-term rental properties when certain conditions are met. The loophole benefits property owners who don't meet the criteria for Real Estate Professional Status (REPS).
If your rental property sat vacant for part or all of the past year, you might be curious whether the tax code still allows you to claim deductions on your ongoing monthly expenses. The good news is that you can still deduct your expenses even when you don't have rental income.
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).
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.
Once you've determined the type of asset you hold, calculate its adjusted cost basis. This calculation is the price you originally paid for the asset minus any accumulated depreciation expenses. Subtract the adjusted cost basis from the asset's sale price to calculate depreciation recapture.
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.
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.
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. If you haven't claimed depreciation on your tax return, you can amend your recent tax return to claim your depreciation benefit.
Depreciation recapture is triggered by a gain on the sale of an asset where the adjusted basis of the asset is used to compute such gain. The adjusted basis of the asset is the original cost basis of such asset reduced by depreciation deductions previously allowed or allowable.
Depreciation Recapture Tax is one of the highest tax rates associated with the sale of real estate, a depreciable asset. 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%.
To calculate the annual amount of depreciation on a property, you'll divide the cost basis by the property's useful life. In our example, let's use our existing cost basis of $206,000 and divide by the GDS life span of 27.5 years. Your depreciation would be $7,490.91 per year, or 3.6% of the loan amount.
To mitigate the impact of the Depreciation Recapture Tax, taxpayers can explore strategies such as like-kind exchanges (under Section 1031) or investing in Qualified Opportunity Zones. These strategies allow for the deferral or reduction of capital gains taxes, including those related to depreciation recapture.
If the fully depreciated asset is disposed of, the asset's value and accumulated depreciation will be written off from the balance sheet. In such a scenario, the effect on the income statement will be the same as if no depreciation expense happened.
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.
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 qualify for the principal residence exclusion, you must have owned and lived in the property as your primary residence for two out of the five years immediately preceding the sale. Some exceptions apply for those who become disabled, die, or must relocate for reasons of health or work, among other situations.
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.
Reduce vacancy time – When a property does go vacant, get it cleaned up for sale or re-rent quickly, aggressively advertise your rental property, and get your vacancy filled. This does not mean taking on a risky tenant. Often the answer is to ask for a little less rent to get you more people from which to choose.
If you've rented out your home for more than 14 days, you generally have to file Schedule E with your income tax return. As I said, the rules can be complicated but don't be discouraged by the details, just be prepared. And do talk to your tax advisor to make sure you have it all under control.
When your rental property expenses are more than income, you usually can't claim the loss since rental activities are passive activities. However, you can claim all or a portion of the loss if an exception to the passive activity loss rule applies.