Understanding depreciation and the benefits

Depreciation allows landlords to recover the cost of their investment in residential rental property over a period of 27.5 years, under the modified accelerated cost recovery system (MACRS). This is typically done using the general depreciation system (GDS), which applies a straight-line method, meaning the same amount of depreciation is deducted each year.

The depreciable amount is based on the taxpayer’s cost basis for the building, excluding the land. Any capital improvements (such as additions, renovations or major repairs) increase this basis.

For example, if a taxpayer buys a rental house for $200,000 and allocates $50,000 to land, the building’s basis is $150,000. Divided by 27.5, the taxpayer can deduct approximately $5,455 per year in depreciation to offset rental income.

See IRS Publication 527: Residential Rental Property (Including Rental of Vacation Homes) for more information.

What is depreciation recapture?

When a rental property is sold for more than its adjusted basis (original cost minus depreciation), the IRS may ‘recapture’ the depreciation deductions previously claimed. This means the taxpayer must pay taxes on the amount of depreciation claimed during ownership, up to a maximum tax rate of 25%.

This tax is in addition to the capital gains tax on any further gain from the sale.

See IRS Instructions for Form 4797: Sales of Business Property for more details.

How it works

Let’s say Dimitri purchased a rental house for $100,000 and claimed $3,636 in depreciation each year for 10 years, totaling $36,360.

He later sold the home for $200,000 without making any improvements. His adjusted basis is now $63,640, which is the original cost of the property ($100,000) minus the total depreciation claimed ($36,360). This adjusted basis is used to calculate the taxable gain, which is the selling price ($200,000) minus the adjusted basis ($63,640), resulting in a taxable gain of $136,360.

Of that gain, $36,360 is subject to depreciation recapture (taxed at up to 25%), and the remaining $100,000 may be subject to capital gains tax (typically 15% or 20%, depending on income).

Strategies to minimize or avoid depreciation recapture

Taxpayers can take proactive steps to reduce the impact of depreciation recapture when selling a rental property. The three most common strategies include:

1. 1031 like-kind exchange

Under Section 1031 of the Internal Revenue Code, taxpayers can defer both capital gains and depreciation recapture taxes by exchanging the property for another like-kind rental property. This strategy allows taxes to be postponed indefinitely until the replacement property is sold without another exchange. However, it’s important to note that the new property must meet strict criteria and timelines, and there are costs associated with the exchange process.

See IRS Publication 544: Sales and Other Dispositions of Assets for further guidance.

2. Inheritance and step-up in basis

If the rental property is inherited, its tax basis is ‘stepped up’ or ‘stepped down’ to its fair market value as of the date of death. This means that the property’s value for tax purposes is reset to its current market value, which eliminates any depreciation recapture liability, as well as any capital gains based on appreciation during the decedent’s ownership.

This strategy is particularly effective in estate planning, as heirs may sell the inherited property with little to no taxable gain.

3. Charitable donation

Donating a highly appreciated rental property to a qualified charity or donor-advised fund can allow the owner to avoid depreciation recapture entirely. Suppose the property has been held for over one year and straight-line depreciation was used. In that case, the donor may claim a charitable deduction for the full fair market value of the property, subject to certain income limits (generally up to 30% of adjusted gross income).

See IRS Publication 526: Charitable Contributions for how to claim this deduction.

Understanding how depreciation recapture works and planning accordingly can empower landlords, helping them avoid unpleasant surprises and significantly reduce their tax liability.

This knowledge puts them in control of their financial future.

Strategies exist to reduce or eliminate the effects of recapture. However, it’s crucial to consult with a qualified tax professional to ensure these strategies are implemented correctly and legally. This professional guidance can give landlords a sense of security and confidence in their tax planning.