One of the primary reasons people choose to invest in multifamily real estate is for the tax benefits associated with owning investment property. Multifamily properties, like all commercial real estate, are highly tax-advantaged. In addition to the cash flow and appreciation potential of real estate, investors can amplify their returns by taking advantage of things like depreciation.
While most investors are quick to highlight the benefit of depreciation, few are as familiar with how depreciation recapture works upon the sale of an asset. In this article, we provide an overview of what multifamily investors need to know about depreciation recapture when selling a property.
What is depreciation?
Before we can discuss depreciation recapture, investors must first understand the concept of depreciation. Rental property, like other business assets, are said to have a “useful life”. The “useful life” of a residential building is 27.5 years. Therefore, the IRS allows investors to depreciate 1/27.5 of the value of their rental property each year (assuming the investor uses straight-line depreciation and not accelerated depreciation).
Even if a property is technically appreciating in value, the owner can write off the value of that depreciation each year. As a real estate investor or property owner, this can result in considerable tax savings. In short, it’s a way to put more money back into investors’ pockets.
The depreciation schedule is the time frame available for the owner to write off an asset’s value.
However, since depreciation affects the amount of taxes someone will owe when selling a property, the IRS will look to recover a portion of those gains. This is the concept of “depreciation recapture”.
What is depreciation recapture?
Depreciation recapture refers to a provision in the Internal Revenue Code that stipulates property owners must pay taxes on financial gains earned when selling a capital asset. Any investor who took depreciation or other deductions while owning the property will generally have some tax liability, per the IRS.
In other words, depreciation should be thought of as a way to defer paying certain taxes. Those taxes will eventually come due, at least in part, through depreciation recapture.
Under current IRS guidelines, the depreciation recapture rate is 25 percent. Any gains that exceed this depreciation recapture rate are then taxed at a lower, long-term capital gains rate—a rate that will vary depending on an investor’s tax bracket (but which can reach as high as 37 percent for those in the highest income brackets). This is a notable difference between depreciation recapture for rental properties and non-real estate property, like equipment and furniture. Depreciation recapture on the latter is taxed using the ordinary income tax rate instead of the capital gains tax rate, which is arguably more favorable.
However, assuming depreciation recapture on rental property is lower than 37 percent, an investor will still benefit from paying less in taxes via depreciation recapture than they would have if they had not taken deprecation in the first place.
Depreciation Recapture: How it Works
As noted above, multifamily property owners can depreciate the value of certain capital assets for tax purposes. Therefore, an investor can buy a fixed asset (e.g., rental property) and then write off the value of that depreciation each year according to IRS guidelines.
This write-off saves the owner money, particularly in the first few years of ownership if they utilize accelerated depreciation. It puts more money back into investors’ pockets sooner than if they did not take depreciation.
Depreciation is intended to account for the normal wear and tear property experiences. The value that an owner writes off as a depreciation expense against the asset is what the IRS will look to partially recover through depreciation recapture upon sale of the property.
Here is a short video explaining how depreciation recapture works:
What rental property can be depreciated?
The IRS allows investors to depreciate the value of any rental property assuming the following statements hold true:
- You are the owner of the property;
- You have owned the property for at least a year;
- You earn rental income from the property;
- The property has a determinable useful life and during that useful life, the property naturally loses value.
Note: land is not considered a depreciable expense since it does not experience normal wear and tear the way that a building does. Therefore, investors must segment the value of the land from the building and other physical improvements. Only the physical structures are eligible for depreciation.
Costs associated with landscaping, clearing or planting are not eligible for depreciation, which the IRS considers a normal cost of owning the land.
Which expenses are deductible when you sell a rental property?
The following expenses are deductible—i.e., they can be used to offset the capital gains tax owed to the IRS—when an investor sells a rental property:
- Property Taxes
- Operating Expenses
- Mortgage Insurance
Although these can all be taken as a lump sum upon sale, best practice is for owners to take the deductions in the same year they incur the expense. These deductions can be reported alongside rental income that an owner reports on their Schedule E tax form.
Certain improvements made to a rental property, including the cost of acquiring the land, may be eligible deductions as well. However, these deductions work differently. Rather than claiming a single large deduction, these improvements are treated as capital expenses and must be depreciated throughout the property’s useful life.
How are depreciation schedules determined?
The IRS establishes the depreciation schedule. The depreciation schedule is the time frame available for the owner to write off an asset’s value. The owner must separately determine the property’s salvage value, which is the estimated value of an asset after its depreciation schedule expires.
The IRS also determines the percentage of an asset’s value a taxpayer can deduct per year (deduction rate), and for how many years they may take the deductions (deduction term).
The actual tax rate for depreciation recapture depends on whether an asset falls under section 1245 (capital property that’s not a building) or section 1250 (real estate property).
How does depreciation recapture work on a multifamily property?
Multifamily properties are said to have a “useful life” of 27.5 years. An owner who plans to utilize straight-line depreciation will therefore take 1/27.5 worth of the value of the property as depreciation each year.
Owners may instead choose to use “accelerated depreciation.” This requires the owner to conduct a cost segregation study, which assigns a useful life for each of the property’s individual components (e.g., the roof, HVAC system, windows, doors, appliances, lighting, fixtures, carpets, etc.).
Based on the value of each individual building component, an owner can front-load depreciation rather than taking an equal portion of the value each year as they would with straight-line depreciation.
Multifamily properties can be depreciated as early as the first year of the owner’s hold period, assuming the property is in service and actively being rented. Owners may need to pro-rate the depreciation expense in the first year of ownership, as it is based upon the first month the rental property was placed into service.
As mentioned earlier, depreciation recapture for rental properties takes capital gains into account when calculating the final recapture value. Therefore, any gains earned from the sale of the property will incur capital gains tax in addition to other taxes and fees.
While the depreciation recapture rate is capped at 25 percent and based upon an individual’s ordinary income tax rate, it applies to the portion of the gain attributed to the depreciation deductions already taken. For some investors, the sale of a property will put them into a higher tax bracket – at least for that year – which means that most will end up paying the 25 percent tax rate upon sale.
So, the IRS taxes a portion of the owner’s earnings as a long-term capital gain (which maxes out at 20 percent), plus the portion related to depreciation. The latter is referred to as the unrecaptured Section 1250 gain and is subject to the higher tax rate of 25 percent. Investors may also be subject to a 3.8 percent net investment income tax (NIIT) and possibly depreciation recapture, even if they have owned the property for less than a full calendar year.
Interestingly, the IRS works from the assumption that owners will have taken depreciation deductions, even if they didn’t and therefore did not benefit from it. Therefore, if someone has not claimed depreciation, they may still be subject to taxes based on what the IRS assumes they should have taken.
How to Calculate Depreciation Recapture
Depreciation recapture is necessary whenever an asset’s selling price exceeds the property’s adjusted cost basis. The owner pays the difference between the two by reporting it as ordinary income.
In other words, to calculate the value of depreciation recapture, the owner must compare the asset’s adjusted cost basis to its sale price.
Depreciation recapture is necessary whenever an asset’s selling price exceeds the property’s adjusted cost basis.
To do so, begin by calculating the asset’s cost basis. This is the price someone paid for the asset. The adjusted cost basis is the original purchase price, less any allowable deductions (including depreciation) expenses incurred during the hold period.
Let’s say someone purchased an asset for $2 million and their depreciation expense was $40,000 per year. To calculate the asset’s adjusted cost basis after four years, you would take $2 million – ($40,000 x 4) = $1.84 million.
For tax purposes, an owner would recapture the depreciation if they had earned income from the sale of the asset. They would then compare the realized gain from the sale of the asset with the accumulated depreciation.
Does depreciation recapture apply when selling a property for a loss?
No. If an owner incurs a loss when selling a depreciated multifamily asset, the IRS will not seek to recover any costs associated with depreciation recapture. It is important to remember that the IRS bases gains and losses on the adjusted cost basis rather than the purchase value.
How to Avoid Paying Depreciation Recapture Tax
There are some scenarios in which an owner may be able to defer paying depreciation recapture tax upon the sale of their multifamily asset. The key is utilizing what’s known as a 1031 exchange.
A 1031 exchange allows an investor to sell a property and roll the proceeds from the sale into another “like-kind” asset of greater value. In other words, if someone expects to have a net gain of $1 million after selling their apartment building, they can use the proceeds of the sale to invest in another multifamily asset of higher value.
Doing so using a 1031 exchange (which has some tedious requirements that investors must follow closely) will allow investors to defer paying both capital gains taxes and depreciation recapture taxes. They will eventually come due when the owner sells the newly purchased property unless the investor uses another 1031 exchange. Many investors will use 1031 exchanges to defer paying taxes indefinitely.
Using a 1031 exchange will allow investors to defer paying both capital gains taxes and depreciation recapture taxes.
Used effectively, a 1031 exchange allows investors to create, store, and transfer their wealth in a tax-free way by enabling them to defer paying a host of taxes. 1031 exchanges require careful planning, but those who do so will realize tremendous benefits and cost savings.
If you own a rental property and are planning to sell it in the near future, consider engaging a tax expert to help you make the most of all available tax-saving tools. A tax consultant will advise you on potential tax liabilities associated with selling the property, how to potentially defer paying those taxes, and how to lower your overall tax liability if subject to depreciation recapture.