Depreciation recapture is a tax concept that allows you to spread the cost of an asset over several years of its useful life and deduct taxes on this amount in each of those years, but the Internal Revenue Service (IRS) collects those taxes when you sell the asset in question.
How does depreciation recapture work?
Not all assets depreciate at the same rate. Cars are known to lose value the moment you drive a new car off the dealership lot, but real estate can appreciate over the years of ownership. You may also realize a profit and capital gain if you sell the property for more than its original cost but have been deducting taxes on its depreciated value during those years of ownership. This is considered a double benefit in the eyes of the IRS and federal tax law.
Therefore, the taxing authority recaptures your depreciation, requiring you to pay taxes you didn’t pay during your ownership because you were claiming a deduction.
Examples of depreciation recapture
For example, suppose you purchased a rental property for $150,000. You allocated its depreciation for tax purposes at a rate of $5,400 per year for five years. You were in the 32% tax bracket in each of those years, so you avoided paying $1,728 each year in taxes you otherwise would have owed: 32% of $5,400 for five years, totaling $8,640 in savings.
You will owe $6,750 in taxes if the tax authority assesses the depreciation you claimed ($27,000 total) at a recapture rate of 25%, and you may also owe capital gains tax. You saved $8,640 in taxes, so in reality, you realized a profit of $1,890 – the difference between $6,750 and $8,640 – because the tax authority effectively recaptured that depreciation.
Not claiming depreciation won’t help
It may seem reasonable that you could choose not to claim a depreciation deduction to avoid paying recapture tax. However, this strategy does not work because tax law requires recapture to be calculated on depreciation that was “allowed or allowable” under IRS tax law.
In other words, you would have been entitled to claim depreciation even if you did not, so the tax authority treats the situation as if you had.
How to plan for depreciation recapture
Here’s some good news: Unused passive activity losses from previous years can be fully deductible when you sell a rental property. This can help offset the tax owed on depreciation recapture.
A rental property can also be sold as part of a like-kind exchange to defer both capital gains and depreciation recapture tax. This involves disposing of one asset and acquiring another similar asset immediately, deferring the taxes until a later time when the sale is not followed by an acquisition.
Additional resources on depreciation recapture
Here are some additional resources from the IRS website regarding depreciation recapture that may be helpful:
- IRS Publication 527, Residential Rental Property
- IRS Publication 544, Sales and Other Dispositions of Assets: Specifically the portion in section 3 that deals specifically with depreciation recapture
- Instructions for Schedule D: Look for the worksheet on page D-14, which helps you calculate depreciation recapture tax
- IRS FAQs on Selling or Trading Business Property and Depreciation and Rentals
Frequently Asked Questions
Can I avoid depreciation recapture?
Generally, you cannot avoid depreciation recapture if you recorded a profit when selling an asset for which you claimed depreciation. Whether you actually took the depreciation when it was available or not, the tax authority will impose recapture tax on you. However, if you sold the property at a loss or exchanged it for a “like-kind” asset of similar value, you will not be subject to depreciation recapture tax.
Where
Do I need to report depreciation recapture?
You must report depreciation recapture on IRS Form 4797, which is used to report the sale of business assets. For any personal gain, you will use Schedule D and Form 1040.
Source: https://www.thebalancemoney.com/depreciation-recapture-3192979
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