Depreciation Recapture & Other Tax Implications of Real Estate Rental Properties
Although rental properties can be a pain to manage and maintain, they can have huge income and equity opportunities. While you own rental real estate, it’s important to take advantage of depreciation and the other tax deductions that will impact your tax return each year. When you are ready to sell, understanding depreciation recapture and planning ahead can significantly minimize your tax obligation.
WHAT QUALIFIES AS RENTAL REAL ESTATE INCOME?
The IRS defines rental income as “any payment you receive for the use or occupation of property.” This can include:
- Normal rent payments
- Advance rent payments (any amount received before the period that it covers)
- Security deposits that are not returned to tenants
- Payments for canceling a lease
- Expenses paid by the tenant (e.g., tenant pays the water and sewage bill for the rental property and deducts it from the normal rent payment)
- Property or services received as rent, instead of money
HOW DOES THE IRS TAX RENTAL REAL ESTATE INCOME?
First, it is important to specify that the IRS treats short-term and long-term rentals differently. Short-term rentals are considered a trade or business (and can trigger self-employment tax depending on the level of services/amenities provided). Long-term rentals are considered passive activities (except for real estate professionals), with the income and expenses reported either on Schedule E for a personal tax return or Form 8825 for a flow-through entity. The rental income tax rate is the ordinary income tax rate determined by your income tax bracket.
That said, many of the expenses to manage and maintain the property (assuming they are “ordinary and necessary” as defined by the IRS) can be used as rental real estate tax deductions to reduce that income. Examples include:
- Operating Expenses (repairs, maintenance, utilities, advertising, landscaping, property management fees, professional service fees, etc.)
- Owner Expenses (home office, travel, subscriptions, continuing education, etc.)
- Mortgage Interest
- Property Taxes
RENTAL REAL ESTATE DEPRECIATION
In addition to the deductions above, depreciation can also be used to reduce taxable income. It is a deduction that occurs over a longer period of time due to the longer useful life of the asset. For IRS purposes, residential real estate is depreciated over 27.5 years, and commercial real estate is depreciated over 39 years. (Excluding the land value as land is not a depreciable asset.) The standard application is to take the cost basis of the building and divide it by 27.5 or 39, depending on the type of real estate. That figure is then used annually until the asset is completely depreciated.
While this general approach will help reduce an owner’s tax burden, there are also ways to maximize depreciation benefits by getting more specific. For example, any components of the property that qualify for bonus depreciation can be broken out and will receive a 100% deduction in the year placed in service. To identify those components, a cost segregation study can be completed to allow for a shorter depreciation schedule in line with their useful life.
HOW CAN A COST SEGREGATION STUDY HELP?
Recently noted by Forbes as one of the most powerful tax strategies, a cost segregation study separates and reclassifies components of the building (such as flooring, lighting, land improvements, appliances, fixtures, etc.) to accelerate depreciation on those items over a shorter time, often 5, 7, or 15 years.
Due to the cost of the service (on average, roughly $5K), cost segregation studies generally make sense for larger properties only (our recommendation is at least $500K), but for those properties – the benefits can be significant.
A client purchased a $3M beach house that was rented out on a short-term basis and not used personally in the first year. The deduction resulting from the cost segregation study was $600K and saved the client over $200K in tax the first year alone. The remaining $2.4M was broken down as $600K in land and $1.8M in building. The $1.8M basis was deprecated over 27.5 years.
DEPRECIATION RECAPTURE ON THE SALE OF RENTAL PROPERTY
While all the noted deductions and depreciation for your rental estate will lower taxable income, when it comes time to sell, the IRS will look to collect taxes that would have been paid without the benefit of claiming depreciation. This is referred to as depreciation recapture and can come as a surprise to some investors. Regardless of whether or not depreciation was taken, the IRS will calculate the depreciation recapture based on the total depreciation expense that should have been taken. This amount can be taxed as ordinary income, not as a capital gain, so it is wise to be prepared and take steps to minimize the impact. Ordinary income is triggered if you took accelerated depreciation on section 1245 property (the $600K in the cost segregation example above). In a way, Section 1250 recapture is in between capital gain and ordinary income. This class of income is still treated as capital gain on Schedule D, but is taxed at ordinary rates, with a cap of 25%.
Here’s how to calculate the depreciation recapture on the sale of a rental property:
- Determine property cost basis (generally the amount paid less the land value)
- Calculate annual depreciation expense (cost basis / 27.5 or 39 based on property type)
- Multiply annual depreciation expense by number of years the property was held
|Depreciation recapture example for a commercial rental property held for five years with a cost basis of $100K:
$100,000 / 39 = $2,564.10 (annual depreciation expense)
$2,564.10 x 5 = $12,820.50 (total depreciation expense)
In this example, $12,820.50 would be taxed at the unrecaptured 1250 tax rate of up to 25%, and the remaining capital gain from the sale would be taxed at the capital gain tax rate of up to 20%.
If sold for $200K, the total gain would be $112,820.50. $100K is a capital gain and $12,820.50 is an unrecaptured 1250 gain.
|Depreciation recapture example for a commercial rental property held for five years with a cost basis of $100K where $20K that was broken out as 1245 property and eligible for bonus depreciation:
$80,000 / 39 = $2,051.28 (annual depreciation expense)
$20,000 = bonus depreciation taken (subject to ordinary income)
$2,051.28 x 5 = $10,256.40 (total depreciation expense on the 1250 property)
In this example, $10,256.40 would be taxed at the unrecaptured 1250 ordinary income tax rate of up to 25%, $20K would be taxed at ordinary rates (up to 37%) and the remaining capital gain from the sale would be taxed at the capital gain tax rate of up to 20%.
If sold for $200K, the total gain would be $130,256.40. $100K is a capital gain, $20K is ordinary income and $10,256.40 is an unrecaptured 1250 gain.
As the ordinary income tax rate can be much higher than the capital gains rate, it can be a material difference. By planning ahead with your CPA, you may be able to utilize some of the tools highlighted below, such as a 1031 tax-deferred exchange or a property basis step-up, to minimize or even avoid depreciation recapture on the sale of property. It’s also very important to remove assets from your depreciation schedule if they are no longer in use. If the $20K in the above example was for flooring that was later replaced, we can avoid ordinary income recapture. You may also be able to allocate the purchase price between assets in order to minimize the ordinary income. For example, if the $200K sales price was broken down as $10K for 1245 property and $190K for 1250 property, our ordinary income would be capped at $10K.
OTHER TAX BENEFITS OF RENTAL REAL ESTATE
- In addition to depreciation, there are other tax-saving benefits that make real estate a great tax tool.
- FICA/Payroll Taxes While general earned income is subject to FICA/payroll taxes, long-term rental real estate income is not.
- 1031 Exchange When selling a property and using the proceeds to purchase a new property (or group of properties), capital gains from the sale can be deferred into the new property
- Rental Real Estate QBI Deduction The Qualified Business Income deduction allows pass-through entities to deduct up to 20% of their rental income (with some restrictions/income thresholds)
- Step-up in Basis A step-up in basis can be used to a ‘reset’ the cost basis of an inherited real estate rental property for tax purposes
While these options and other tax laws around real estate investing can be confusing, if done right – the benefits can be considerable. You can use debt to buy an appreciating asset that has the current tax benefits listed above and can provide cash flow while also creating a tax loss.
Navigating the ins and outs of real estate investing can raise a lot of questions. With proper tax planning, rental real estate can be an excellent tool to create generational wealth for years to come. Have questions? Contact us today.