Will I have to pay back all my tax savings? No, when you sell a property after claiming depreciation, you do not pay back all the tax savings; rather, the IRS requires you to “recapture” or pay tax on the portion of your gains attributed to the depreciation previously taken. This tax is applied to your profit, and the effective rate depends on the type of property:
Real Property (§1250 Property): Depreciation is recaptured at a maximum rate of 25%.
Personal Property (§1245 Property): Recapture (often including Bonus Depreciation) is taxed at your ordinary income tax rates (up to 37%).
The good news is that any remaining profit beyond the depreciable value is taxed at lower capital gains rates, and proper tax planning, like executing a §1031 Exchange or buying a new property for a Cost Segregation study, can help you defer this tax burden entirely.
Depreciation Recapture on Sale: Key Facts
- Recapture Myth: You do not pay back all the tax savings; you pay tax on the portion of your sales gain equal to the depreciation taken.
- Recapture Rate for Real Property (§1250): Depreciation is recaptured at a maximum rate of 25%.
- Recapture Rate for Personal Property (§1245): Recapture (including Bonus Depreciation) is taxed at ordinary income tax rates (up to 37%).
- Remaining Profit: Any profit on the sale that is not attributed to depreciation is taxed at typically lower capital gains rates.
- Tax Deferral Strategies: Proper planning, such as using a §1031 Exchange or buying another property that Engineered Tax Services (ETS) can cost segregate, can help defer the entire tax burden.
What is Depreciation Recapture?
Depreciationis a valuable tax strategy that allows businesses and real estate investors to deduct the cost of assets (like equipment, rental properties, and commercial buildings) over time, accounting for wear and tear.These deductions reduce your annual taxable income.
Depreciation recaptureis the tax rule that comes into play when you sell that asset for a profit (a gain).The IRS requires you to “recapture” or reclassify a portion of that sales profit as ordinary income, up to the total amount of depreciation previously claimed. This prevents you from benefiting from tax deductions at your ordinary income rate, only to have the resulting gain taxed entirely at a potentially lower long-term capital gains rate.
How Does the Recapture Tax Work?
The calculation of recapture taxdepends on the type of asset sold:
- Real Property (Section 1250):For rental real estate, commercial buildings, etc., the gain attributable to the claimed depreciation is generally taxed at a maximum federal rate of 25%.Any profit beyond the total depreciation amount is taxed at the typically lower long-term capital gains rate.
- Personal Property (Section 1245):For assets like equipment, machinery, or vehicles, all prior depreciation claimed (including accelerated depreciation methods) is generally subject to recapture of depreciationand is taxed at your higher ordinary income tax rate.
It's important to note that depreciation recaptureis only triggered if you sell the asset for a gain. If you sell the asset at a loss, there is no recapture. The amount of the recapture is limited to the lesser of the total depreciation claimed or your total gain on the sale.
Strategies to Mitigate Recapture
While recapture is a standard part of the tax code, you can employ tax planning strategies to defer or offset the tax liability:
- 1031 Exchange:By reinvesting the proceeds into a “like-kind” property, you can defer both capital gains and depreciation recaptureuntil the newly acquired property is eventually sold.
- Cost Segregation Impact:If you utilized a cost segregation study to accelerate depreciation, you received a greater up-front tax benefit. However, this also increases the amount subject to recapture upon sale, making an exit strategy, like a 1031 Exchange, even more critical.
