What Happens to the Depreciation When I Sell My Investment Property?

By
Services for Real Estate Pros with Exeter 1031 Exchange Services, LLC

Depreciation

This is an excellent question.  There are many taxpayers who do not fully understand exactly how depreciation works, how it reduces their income taxes by sheltering some of their rental income, and most importantly what happens to the depreciation when they ultimately sell their rental property without using the 1031 exchange

Depreciation Recapture

Taxpayers must depreciate their rental property.  It is not an option.  The depreciation taxpayers have deducted on their income tax return during the time they owned the rental property must be recaptured or added back into their taxable income as depreciation recapture when they sell their rental property without structuring a 1031 exchange. 

Depreciation Recapture Is Mandatory

It is extremely important to note that depreciation recapture taxes will be calculated and assessed by the Internal Revenue Service whether or not the taxpayer actually took (booked) depreciation on his or her income tax return, so taxpayers must always depreciate their rental properties even if they do not receive any immediate benefit from the depreciation. 

Depreciation Recapture Income Tax Rates

The Federal and state income tax rates applied toward depreciation recapture can vary depending on when the property was placed into service and what depreciation method is being used.  Depreciation recapture is taxed at a higher rate than capital gains. 

Generally, Federal capital gains are taxed at a maximum income tax rate of 15% and depreciation recapture is taxed at a flat income tax rate of 25%, plus any applicable state or local income taxes. 

Taxpayers should always have their tax advisors compute the actual amount of depreciation recapture as well as capital gains prior to completing any sale of rental property in order to avoid any unpleasant surprises when the file their income tax return. 

Deferring Depreciation Recapture Income Taxes

Depreciation recapture, like capital gains, can not be avoided except by death, which is not a very effective or desirable tax planning strategy.  Taxpayers can defer both by structuring a 1031 exchange and acquiring replacement property.  The depreciation recapture and capital gains are deferred (transferred) into the newly acquired replacement property. 

Defer Capital Gains Indefinitely

Unfortunately, capital gains and depreciation recapture taxes can only truly be avoided by the death of the taxpayer.  The taxpayer continues to 1031 exchange throughout his or her lifetime and will therefore continue to defer the payment of his or her capital gain and depreciation recapture taxes indefinitely.  The tax liabilities are continuously deferred throughout his or her lifetime, and they actually go away at his or her death because their heirs will receive a step-up in cost basis. 

Step-Up In Cost Basis

The fair market value of the taxpayer's rental property is included in his or her estate and may be subject to estate taxes (inheritance taxes).  Because the property is taxed as part of the estate at the fair market value at the date of death, the heirs will receive a "stepped up" cost basis upon death.  The heirs cost basis becomes the fair market value of the rental property on the taxpayer's date of death. 

Capital Gain and Depreciation Recapture Taxes Avoided

The capital gain and depreciation recapture taxes completely disappear and the taxpayer's heirs could immediately sell the property and pay no income taxes.  In fact, they may even sell at a loss in the current market cycle and be able to write off a loss on the sale.  They should consult with their income tax advisors to see how they would be affected. 

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  1. Tim Maitski 08/21/2008 05:33 AM
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Show All Comments
Rainer
179,085
Erik Hitzelberger
RE/MAX Alliance - Louisville REALTOR-Luxury Homes - Louisville, KY
Louisville - Middletown Real Estate

Bill - You have a substantial amount of quality information here.  I'm bookmarking this to study later.  BTW, your comment about death being an ineffective and undesirable tax avoidance plan was hilarious.

August 21, 2008 12:56 AM #1
Rainmaker
130,809
Bill Exeter
Exeter 1031 Exchange Services, LLC - San Diego, CA
1031 Tax-Deferred Exchange Expert

Hi Erik,

I'm glad you liked the information.  And glad you liked the comments.  I have to be careful when I use those terms.  The swap until you drop comment does not go over well with certain audiences!  Thank you for stopping by and commenting. 

August 21, 2008 01:21 AM #2
Rainmaker
620,604
Randy Prothero
Island Style Realty Inc. - Mililani, HI
Hawaii REALTOR, (808) 384-5645

I know many folks do not realize that taking depreciation is not an option.  I have recommended to more than one client they speak to a tax professional, because they were confused.

August 21, 2008 02:37 AM #3
Rainmaker
130,809
Bill Exeter
Exeter 1031 Exchange Services, LLC - San Diego, CA
1031 Tax-Deferred Exchange Expert

Hi Randy,

You are so right.  This is the one area where real estate investors always seem to get the biggest surprise at tax time.  They never meet with their tax advisor in advance like they should, and then end up with an unexpected income tax problem at tax time.  It can usually be avoided with a simple phone call to their tax advisor before they complete a transaction. 

Thank you for visiting our blog and commenting!

August 21, 2008 08:42 AM #4
Rainmaker
130,809
Bill Exeter
Exeter 1031 Exchange Services, LLC - San Diego, CA
1031 Tax-Deferred Exchange Expert

Hi Ken,

Thanks for dropping by.  No, we are not going to LV.  I've been really disappointed with the educational component.  We stopped going a coupld of years ago. 

August 22, 2008 03:03 PM #6
Anonymous
Anonymous
Jemanos

Hi Bill:

This is excellent info. Say, I was wondering: I understand depreciation is not an option but what happens if someone didn't realize after 8 years that they were supposed to have been depreciating their rental property and all of a sudden their new tax man tell them so but the tax man doesn't necessarily know if there is a way to recapture the depreciation for the past years?  Do you or someone here know if there is a solution for something like that?

I know that you can ammend the last 3 years but 8 years? Also, the issue of bldg and land value will be hard to find out that far back.

Any comments advise here? Would greatly appreciate any imput.

Jemanos

January 30, 2010 02:23 AM #7
Rainmaker
130,809
Bill Exeter
Exeter 1031 Exchange Services, LLC - San Diego, CA
1031 Tax-Deferred Exchange Expert

Great question, and actually a very common question.  I speak to taxpayers virtually each and every week that did not depreciate their rental properties on their income tax returns. 

The first thing they need to be aware of is that taking depreciation is mandatory (not optional).  The taxpayer will still have to recognize and pay tax on depreciation recapture when the property is sold whether he or she actually took depreciation or not on their income tax returns.  They can continue to defer it if they continue structuring 1031 Exchanges. 

The next thing is what to do about the back tax returns.  There can be many issues and moving parts involved here, so it is very important that they hire and consult with a competent tax advisor.  I generally look to see how much depreciation is involved.  The amount may be so minimal or the impact to the actual tax liability may be negligible, that it is not worth amending prior tax returns. 

However, if the amount and bottomline impact is significant, then the taxpayer should look at amending his or her tax returns.  You can go back further than 3 years, but you also start the statute of limitations running all over again for those tax years - so be very careful here.  Again, it is important to consult with a tax advisor, because taxpayers do not always know what they don't know. 

January 30, 2010 05:06 PM #8
Anonymous
Anonymous
Jemanos

Thanks for the comment Bill on the depreciation. Now I have another question: What happens to those people that got the $7500 as a loan from the IRS for first time buyer last year but later the amount was changed to $8000 as credit. Do they have to file an ammend to get under the other category or was the loan converted to credit automatically without having to be paid back???

Thanks in advance again!

February 05, 2010 08:54 PM #9
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