An investment in rental property can be profitable, providing steady income and potential appreciation in value over time. It is, however, depreciation recapture that frequently catches landlords off guard during the sale of a rental property. Depreciation recapture occurs when you sell a property for more than its depreciated value, and it can lead to a significant tax hit.
In this blog post, we’ll explore strategies to help you minimize or avoid depreciation recapture from a US perspective.
Understanding Depreciation Recapture:
Depreciation is an accounting method that allows you to deduct the cost of your property over time, typically 27.5 years for residential real estate. When the property is sold, the IRS recaptures the tax benefits received from depreciation by imposing a higher tax rate on the gain compared to the capital gains tax.
Depreciation recapture is subject to taxation at the individual’s ordinary income tax rate, which can be as high as 25%. Any remaining profits from the sale of assets are then subject to capital gains tax, which can be taxed at a rate of 0%, 15%, or 20% depending on the individual’s income level.
- 0% Capital Gains Tax Rate: This applies if the investor is in the lowest tax bracket.
- 15% Capital Gains Tax Rate: Applies to investors in the middle-income tax brackets.
- 20% Capital Gains Tax Rate: This applies to investors in the highest tax bracket.
Strategies to Avoid or Minimize Depreciation Recapture:
Now, let’s understand the strategies to avoid depreciation recapture on rental property.
- Use 1031 exchange:
The 1031 exchange, also known as a like-kind exchange, is a valuable tool for real estate investors. It provides a strategic way to delay capital gains tax and depreciation recapture. This means that you have to buy another property either with the same value or more within 45 days of the initial sale. This can be a significant tax savings for investors who are selling real estate that has appreciated in value.
Another benefit of a 1031 exchange is that it allows investors to upgrade or diversify their real estate portfolios without having to pay taxes on the sale of their existing properties. But you should keep in mind that the 1031 exchange is only available for real estate properties that are held for investment or business use.
- Invest in opportunity zones:
Opportunity Zones are designated economically distressed areas where investors can receive tax benefits, including deferral or reduction of capital gains taxes. By investing in these zones, you may be able to minimize the impact of depreciation recapture.
- Use a cost segregation study:
A cost segregation study can help you identify and accelerate the depreciation of certain components of your rental property, such as appliances, fixtures, and improvements. This can help you to reduce the amount of depreciation recapture you owe when you sell your property.
- Take advantage of the 121 primary residence exclusion:
If you decide to sell your rental property and use the money to buy a new primary residence, there is a possibility that you can exclude up to $250,000 of the gain from being taxed under 121. This exclusion can be beneficial in lowering your capital gains tax liability, which includes the part of the gain that comes from depreciation recapture.
- Sell your rental property to a qualified family member:
When you decide to sell your rental property to a family member who meets the necessary qualifications, there is a possibility to postpone the payment of capital gains taxes through 1041. Essentially, this means that you won’t be required to pay taxes on the profit until your family member decides to sell the property. It is crucial to remember that this deferral option does not apply to depreciation recapture.
- Strategic timings of sale:
Timing is crucial when it comes to selling rental properties. By selling a property with low or no appreciation, you can potentially reduce the impact of depreciation recapture.
Rather than selling the entire property at once, consider selling a portion of it. This allows you to spread the depreciation recapture over several years, potentially resulting in lower tax liabilities. Additionally, using an installment sale can further defer taxes by spreading the gains over time.
- Use trust structure:
Establishing a trust to hold your rental properties can be a strategic move. When structured correctly, a trust can provide tax advantages and potentially mitigate depreciation recapture. Consult with a tax professional and legal advisor to explore the trust options available and ensure compliance with applicable laws.
- Stay informed about tax laws:
Tax laws are subject to change, and staying informed is crucial to making strategic decisions. Regularly review updates to the tax code and consult with tax professionals to adapt your investment strategy accordingly.
Tax consequences of depreciation recapture and how investors can plan for them
- Estimating your depreciation recapture liability:
Investors can estimate their depreciation recapture liability by tracking the amount of depreciation they have claimed on their rental property over the years. This can help investors to budget for the tax liability they will owe when they sell their property.
- Setting aside funds to pay depreciation recapture taxes:
Investors can set aside funds to pay depreciation recapture taxes by investing in tax-advantaged accounts, such as retirement accounts or health savings accounts. This can help investors to reduce the amount of money they have to pay out of pocket when they sell their property.
- Working with a tax advisor:
Investors should work with a tax advisor or industry expert to develop a tax plan that minimizes their tax liability, including their depreciation recapture liability. A tax advisor can help investors to choose the best tax strategies for their individual situation.
Key Takeaway:
While depreciation recapture may seem like an inevitable consequence of selling a rental property, proactive planning, and strategic decision-making can help minimize its impact. By exploring the options mentioned above, you can take control of your tax liability and make the most of your real estate investments. Remember to consult with a tax professional to ensure that your approach aligns with the current tax laws and regulations. Explore our free blogs and webinars for more such helpful content and educational webinars.
