Last updated on June 24th, 2021 at 12:07 pm
Use a 1031 exchange to avoid depreciation recapture tax | Sell the rental property for a loss | Determining depreciation recapture tax | Avoiding depreciation recapture tax impact | FAQs
Most investors know capital gains taxes can take a big bite out of their profits from the sale of a rental property. But many don’t realize depreciation recapture tax can be just as substantial.
Many investors dread depreciation recapture tax for two reasons:
- Their depreciation recapture tax rate can be even higher than their capital gains rate.
- Depreciation recapture tax is a tax on savings you enjoyed in the past, and not money you have in hand.
Luckily, you can avoid depreciation recapture tax on a rental property.
One of the best methods is to use a 1031 exchange. Using a 1031 exchange enables investors to defer most, if not all, of their depreciation recapture tax, not to mention their capital gains tax.
Using a 1031 exchange doesn’t eliminate your taxes. It simply defers those taxes until some point in the future. Think of it like kicking a can down the road. You’ll still have to decide what to do about them, but not for a while.
Possibly a very long while.
Let’s touch on some of the best ways to avoid depreciation recapture tax.
Use a 1031 exchange to avoid depreciation recapture tax
When you sell an investment property for a profit, the IRS wants you to pay taxes on that gain.
The good news: IRC Section 1031 allows you to defer the payment of capital gains and depreciation recapture taxes if you structure your transaction as a 1031 exchange.
What is a 1031 exchange?
Basically, it allows you to “trade” your investment property through a third party intermediary for a new investment property.
Since the transaction is handled through an intermediary you haven’t technically realized any gain from the exchange, which means you won’t have to pay any taxes on the transaction.
A 1031 exchange is an incredibly powerful way to manage your investments and avoid depreciation recapture tax and capital gains tax.
Let’s look at an example to see just how much money you could save by doing a 1031 exchange.
Say you bought a $300,000 rental property and owned it for 11 years. Each year you were eligible to claim $8,182 in depreciation. After 11 years, you’ve claimed a total of just over $90,000 in depreciation.
If you sold this property outright for $500,000, you’d be on the hook for a depreciation recapture tax of up to 25% on the $90,000 of depreciation, which would come to around $22,500.
You’d also face capital gains of $55,000, if you fell into the highest tax bracket.
That’s a whopping $77,500 tax bill.
However, if you used a 1031 exchange, you could bring that tax bill down to zero.
The basic rules of a 1031 exchange
|To do a 1031 exchange: |
If you’re thinking of embarking on this kind of investment journey, your first step should be to consult with an expert.
Contact us today and we’ll connect you with seasoned, knowledgeable 1031 exchange professionals.
Sell the rental property for a loss to avoid depreciation recapture tax
Depreciation recapture tax and capital gains tax are assessed on your gains. That is, the profit you make on the sale of your property.
So if you sell that property for a loss, you won’t have to pay any taxes on the sale.
Let’s revisit the example from above to illustrate how this works.
You bought a $300,000 investment property, claiming $90,002 in depreciation over 11 years of ownership. Then you sold the property at a loss for $100,000.
Because you sold at loss, you wouldn’t have to pay any depreciation recapture tax.
Since you owned this property for more than a year, you’d file this loss under the Section 1231 loss category. You’d be able to use this loss to reduce your tax liability during the current or past two years of taxable income.
|🔑 Editor’s note: This is a rare scenario. Selling at a big loss usually means there’s been a significant market collapse. That simply doesn’t happen very often.|
How to determine depreciation recapture tax on a rental property
To determine depreciation recapture tax on a rental property, we have to understand how depreciation is calculated.
When investors buy a rental property, the IRS allows them to take an annual tax deduction based on the depreciation of the property over 27.5 years. This comes to a depreciation rate of 3.636% of the property’s cost basis annually.
Let’s use the scenario from above again. If you bought a rental property for $300,000, you’d divide the building value by 27.5 to come up with the annual depreciation.
|🔑 Editor’s tip: Note that we use only the value of the structure. Land doesn’t depreciate.|
Assuming the land is worth $75,000, that gives us a building value of $225,000.
$225,000 divided by 27.5 equals $8,182 of depreciation, which you can deduct each year.
However, when you sell this rental property for a profit, the IRS will want to recapture some of the depreciation you claimed. This is where depreciation recapture tax comes in.
How is depreciation recapture tax calculated?
Depreciation recapture is taxed as ordinary income. That means your depreciation recapture tax rate is going to be the same as your income tax rate, although depreciation recapture tax is capped at 25%.
The chart below breaks down what your depreciation recapture tax rate will be, depending on your income bracket.
|Rate||Single filers||Married filing jointly||Head of household|
|10%||Up to $9,875||Up to $19,750||Up to $14,100|
|12%||$9,876 to $40,125||$19,751 to $80,250||$14,101 to $53,700|
|22%||$40,126 to $85,525||$80,251 to $171,050||$53,701 to $85,500|
|24%||$85,526 to $163,300||$171,051 to $326,600||$85,501 to $163,300|
|25%||$163,301 and up||$326,601 and up||$163,301 and up|
» How much depreciation recapture tax will you owe? Find out with our depreciation recapture calculator.
Why avoiding depreciation recapture tax using a 1031 exchange can be a big deal
Once you understand how big of a bite depreciation recapture tax can take out of your profits, the power of a 1031 exchange becomes clear.
Remember: As long as you meet the timelines and requirements of your 1031 exchange, you can defer all of your depreciation recapture taxes, as well as your capital gains.
Using the example sale described above, here’s a side-by-side comparison of the savings of a 1031 exchange vs. a taxable sale.
|Taxable sale||1031 exchange|
|Total tax liability||$77,500||$0|
On this sale, an investor would save over $77,000 by opting for a 1031 exchange over a taxable sale.
Planning on selling an investment property, but want to avoid depreciation recapture tax? Talk to an expert. Contact us now and we’ll put you in touch with a pre-vetted, highly experienced 1031 exchange specialist.
Can I move into my rental property to avoid depreciation recapture?
Moving into a rental property can help you avoid some capital gains tax, but it won’t reduce your depreciation recapture tax.
If you want to use this strategy to reduce your capital gains tax, you have to live in the property for two years before you sell it, and own it for at least five years.
Once you establish it as your primary residence, you’ll be able to exclude a proportion of your gain from taxation.
Can I avoid depreciation recapture by not claiming depreciation on the rental property?
Even if you don’t claim depreciation on your rental property each year, the IRS accounts for it when you sell the property.
According to IRC section 1250(b)(3), recapture is calculated on depreciation that was “allowed or allowable,” regardless of whether it was actually claimed.
That means you should always claim any depreciation you’re eligible to deduct, since you’ll be responsible for depreciation recapture tax when you sell.