Tax benefits have become one of the main reasons to invest in rental properties. Typically, when you own a property, there is an inevitable offset of depreciation expense that balances out the taxable net income. But when it comes to selling a rental property, the IRS mandates real estate owners to recapture depreciation expenses that came from paying taxes.
Fortunately, investors can defer or cut out the need to pay depreciation recapture tax in order to maximize profit and increase cash flow. Most investors understand that taxes from capital gains can impact their profits from selling a rental property. But more investors need to realize and recognize that depreciation recapture tax is also important.
No Investor wants to incur deprecation recapture tax. After all, the deprecation recapture tax can be higher than the actual capital gains. Many investors take depreciation expense for granted, but depreciation recapture tax sits on top of your savings.
What Exactly Is Depreciation Recapture?
At its core, depreciation recapture is a comprehensive policy by the IRS that restricts the ability of a person to get a depreciation deduction, which impacts their net income tax. From the perspective of the IRS, selling a rental property with a sizable profit should involve depreciation recapture tax.
The IRS also requires people to report their profits as income, not capital gains. The “recaptured” value involves taxing at a lower bracket by calculating the difference between the adjusted cost and sales price. Remember, a rental property can depreciate at a lesser or higher rate than the market rate.
Tax experts concur that it is difficult to track actual depreciation due to several dependent factors. When you decide to sell a rental property, the IRS checks your profits. And this allows the IRS to determine whether the rental investor wrote off more value than the depreciation.
Mechanics of Depreciation on a Rental Property
Rental property owners often get caught in the cobweb of depreciation on their rental property. Of course, technicalities can be complex if you’re not a tax professional. Contrary to misguided perception, calculated depreciation does not revolve around the market value of a real estate property.
Instead, you determine depreciation based on the closing cost of a real estate property. Closing costs include recording fees, debts, title, and property taxes. In 2022, the IRS has set the recovery period for a rental property at 27.5 years, representing 3.63% per year. The calculation involves writing off closing costs and adding up all these expenses for the recovery period.
How Rental Property Owners Can Avoid Depreciation Recapture
Real estate investors no longer want to pay a high tax that would decrease their profit margins. Keeping that in mind, here are the three ways to avoid depreciation recapture tax on your rental property:
Make the Most Out of 1031 Exchange
Section 1031 is part of the Internal Revenue Code that makes it possible for real estate owners to avoid capital gains tax. In fact, Section 1031 allows real estate investors to defer other income liabilities, especially depreciation recapture.
So, the next time you buy another property with a similar value to your current property, take advantage of the 1031 exchange. In the context of the 1031 exchange, when you sell a rental property, use your funds to buy another property with a similar value without paying capital gains tax or depreciation recapture.
But to leverage the 1031 exchange, real estate investors first have to utilize the sale proceeds of the first property to invest in another property. As a real estate investor, understand that using the 1031 exchange delays your depreciation recapture and capital gains taxes.
In hindsight, it is a practical and technical approach to avoid depreciation recapture. With the 1031 exchange, real estate owners are not receiving profits from the sale of a property as long as they use the funds to support future business efforts.
Transfer the Legal Ownership of the Rental Property to an Heir
As effective and practical 1031 exchange is – it is not the only way real estate investors can avoid depreciation recapture tax. Rental property owners can transfer the ownership of their estate and leave it to one of their heirs to avoid depreciation recapture tax.
In case of your departure, heirs will inherit your rental property and won’t have to pay capital gains tax. When real estate investors leave a rental property to an heir, the closing cost comes close to the current value. As a result, it automatically resets the clock of depreciation.
Make the Rental Property Primary Residence
The third option to avoid depreciation recapture tax is to make a rental property a primary residence. When a rental property becomes a primary residence for 2-3 years, it allows real estate owners to avoid the property’s capital gains tax. But if you decide to sell your rental property, you would still have to deal with some aspects of depreciation recapture.
Real estate owners need to understand that the IRS can take away what it offers as an incentive. Of course, real estate investors are aware of the tax benefits of depreciation. Unfortunately, the IRS utilizes a depreciation recapture mechanism to extract some of these tax benefits when selling a real estate property. When you don’t want to deal with depreciation recapture tax on your rental property, follow the best practical solutions.
Depreciation recapture tax does not change the fact that depreciation is a reliable tool for investors to save a lot of money on their rental properties. The IRS can be generous and allows real estate investors many deductions. But it is imperative to keep an eye on your total write-offs to be on the safe side.
In the end, when you sell a rental property, the IRS reclaims a part of your initial deduction. You’d be surprised how many real estate investors find out they have to cover or return some of the depreciated amount for the first time. In retrospect, real estate investors should seek out the expertise of a tax specialist to avoid depreciation recapture tax.