If you’re a real estate investor, and you’re planning to sell an income property owned for more than one year, you’re probably aware you will pay a capital gains tax. What you might not be aware of is the depreciation recapture tax you will also pay, and may be in for an unpleasant disappointment.
This was suggested to me recently by an real estate investor who never saw the recapture tax coming. Only to discover it later when his federal tax obligation computed higher than he originally anticipated, and the proceeds he expected to receive computed lower. This is not a good thing. So it seems appropriate to mention it as a bit of income property advice to the new real estate investor.
Depreciation recapture tax occurs when depreciable real estate is sold after one year of ownership. Property sold one year or less is classified as a short-term gain and gets taxed as ordinary income; so it’s irrelevant. Capital gains and the recapture tax only apply to a property held for more than one year.
In real life, here’s how it works. When you sell an income property and have a recognized gain, the feds want to tax you for the capital gain, plus they want to tax you for the accumulated depreciation you’ve taken during the years you owned the property. Because the current capital gains tax rate is 15% and the recapture tax rate is 25%, you wind up paying more tax (thus, get to keep less) at the sale of your property than you would have by having to pay just the capital gains tax alone.
For example, if you realize a gain of $300,000 of which $100,000 is attributable to depreciation, your taxes might compute this way:
1. Your accumulated depreciation of $100,000 gets taxed at 25%. Hence, you owe $25,000 recapture tax. 2. The $200,000 remainder (300,000 – 100,000 = 200,000) gets taxed at 15% (the current capital gains tax rate). Hence, you owe $30,000 capital gains tax. 3. Your tax obligation for real estate capital gains totals: 25,000 plus 30,000. Hence, you owe $55,000.
Now suppose you had no knowledge of depreciation recapture tax. You would probably assume when you sell that your full gain will be taxed as capital gains. In your mind, the full $300,000 gain gets taxed at 15%, and thereby conclude that you owe the IRS $45,000. Imagine the shock when you learn that you owe $55,000; a whopping $10,000 more tax than expected; hence, $10,000 less proceeds than expected (say goodbye to the wide-screen television).
The bottom line? Real estate investing requires sound real estate investment tax strategies. So you should always consult a tax specialist before you sell rental income property, and maybe think about investing in a good real estate investment software program. It might keep you from getting blindsided at tax time, and likewise prevent unrealistic expectations that result in an unpleasant disappointment later.
About The Author
James R Kobzeff is a licensed real estate broker and developer of ProAPOD Real Estate Investment Software: Cash flow, rate of return, and profitability analysis software for rental income property. Made for realtors and investors. REALTOR(r)Magazine calls ProAPOD a “Cool Tool.” http://www.proapod.com