How does recapture of depreciation work

They will then assess the tax on what you should have taken — even if you never benefited from the deduction. How can I avoid paying tax on my depreciation deductions? Many investors consider taking advantage of Section of the IRS tax code.

Commonly referred to as a exchange, this section allows investors to defer paying taxes when they sell investment real estate and reinvest the proceeds from the sale in investment real estate of equal or greater value.

Taxes that need to be paid on depreciation recapture, federal capital gains, state taxes, and NIIT are all deferred. Effective use of a strategy allows investors to create, store, and transfer wealth tax-free. It would be best if you planned in advance to take advantage of this deferment strategy. You should always contact a exchange specialist before selling your current property. Millcreek Commercial specializes in exchange strategies.

Exchanging residential rental properties for other rental properties is often a net-zero trade—one set of headaches for another. However, exchanging residential rental properties for high quality, NNN leased commercial real estate can bring the safety, security, and stability your portfolio deserves. Many investors fill the role of landlord. In general, any legitimate expenses that relate to your rental property can be deducted, such as:.

All these deductions can be taken during the same year in which you spend money. Just report the deductions on your Schedule E form. But remember, if you sell the rental property, the IRS will tax you on the depreciation deductions!

You fully use the property for your business or another income-producing activity, like renting to tenants. The rental property in question has a set useful life. In other words, the rental property has to eventually wear out, become obsolete, or lose its value.

It has to depreciate. Luckily, all rental properties qualify for this attribute. On the other hand, the IRS also places some limitations on properties you cannot depreciate. These include:. Rental properties that you put in service and sell to another investor within the same fiscal year. You also cannot depreciate the costs for landscaping, planting, or clearing land. The IRS considers those costs to be part of the overall cost of purchasing and developing land. It can be tough to know when to start deducting depreciation for your rental investment if there are multiple major dates in your investment journey.

Under these rules, you can start depreciation for your tax breaks on April Different classes of assets, such as vehicles, rental properties, and expensive equipment, have different depreciation limits or caps. According to this system, any residential rental property has a useful life of approximately For a real estate investor, this means you can depreciate 3. Note that the cost basis also includes ancillary fees like title fees, transfer fees, and more.

The cost basis further includes the improvements you might make to a rental property after buying it. These can include amenities like pools or gyms for tenants, AC, and so on. Note that the cost basis does not include other costs, such as:.

Even with these guidelines, rental property depreciation can be difficult for investors that need to depreciate partial years of rental property ownership. Say that your rental property has only been in service for part of the year. Fortunately, the IRS breaks down how much you can depreciate for a rental property based on whichever month you put it into service. The depreciation values are:. January: 3. Remember that your cost basis only covers the value of the building, not the land or any improvements to the land you may have ordered.

The cost basis does include the closing costs, improvements to the property directly, and so on. You can keep depreciating your property until the You abandon it, you sell it or exchange it for another property, you convert it to a different use, or it is destroyed.

If you could start depreciating this property in April, you would have a depreciation rate of 2. The equation to use would be:. Remember, the percentage of depreciation is represented mathematically two places from the decimal point when calculating. Therefore, depreciation recapture will almost certainly kick in once you sell the property. After all, the depreciation expenses lowered your cost basis for the property over several years. On April 1, the house is good to go, so you start advertising.

You find a tenant and the lease starts June 1. With three different dates -- Jan. Residential rental property placed into service after is depreciated using the Modified Accelerated Cost Recovery System MACRS , an accounting system that spreads depreciation deductions over the "useful" life of the property. Residential rental property has a useful life of This means you depreciate 3.

The cost basis is the amount you paid to buy the property whether you paid cash or financed it , including sale of the property, transfer, and title fees. Your cost basis also includes the cost of any improvements you make beyond buying the property.

The improvements must be a "material part of" and add "real" value to the property. To add "real" value, the improvement must give an appraiser good reason to bump up the value of the property. A new deck or a substantial kitchen remodel qualify for this. GDS applies to most rental properties placed. You must use ADS if the property:. If you are required to use ADS, you depreciate the property over 30 years if it was placed in service after Dec.

If it was placed in service earlier, you depreciate over 40 years. Instead, the IRS tells you exactly how much you can depreciate based on the month you put the rental property into service:.

Click to enlarge. In our example, you put the home into service during April, so you depreciate 2. Remember, the cost basis uses the value of the building and not the land. The cost basis also includes closing costs and any improvements you make beyond buying the property.

You continue to depreciate for up to The property is considered retired from service when:. At some point, you may want to sell your rental property. Because depreciation expenses lower your cost basis in the property, they ultimately determine your gain or loss when you sell. That's what depreciation recapture does. Depreciation recapture applies to the lesser of the gain or your depreciation deductions.

Provided you owned the property for more than a year, the loss is considered a Section loss , which means it can be used to reduce your tax liability during the tax year. Or you can carry it forward to offset future income for up to 20 years. Keep in mind that these examples are overly simplified.

Also, rental property tax laws are complicated and change periodically. Unless you're a real estate tax law rock star, you should work with someone who is. Find a qualified tax accountant when you establish, operate, and sell a rental property.