Whether you own and manage properties independently or have multiple partners in commercial real estate projects, investing in real estate is a proven method for building wealth.
Part of the appeal is the tax benefits, including the ability to deduct depreciation lowering your annual taxable income. However, when you take depreciation on the front end, the IRS requires you to add it back at the time of the sale, more commonly known as depreciation recapture.
Depreciation allows you to recognize the gradual decrease of certain assets as they decline in value over time. It also reduces the cost basis of the property for tax purposes.
In some cases, you can accelerate depreciation or take advantage of bonus depreciation to increase the deduction expense in the early years of ownership. Regardless of how you take it on the front end, the IRS forces you to “pay it back” when you sell.
The Tax Benefits of Depreciation Versus Taxation on Depreciation Recapture
Depreciation recapture at first appears to offset the tax advantages of writing off depreciation during the years of ownership. But aside from the benefits of deferred taxation, the tax rate also matters.
The IRS taxes annual income or profits from your real estate business at the earned income rate. Depending on the business structure, this amount could be at your personal income or corporate tax rate.
LLCs, commonly used for real estate investments, are considered pass-through entities by the IRS and pay taxes at the individual tax rate, which could be as high as 37%, depending on household income.
The IRS taxes depreciation recapture as ordinary income but caps the rate at 25%. This cap applies to both straight-line and accelerated depreciation. Therefore, you can still receive a tax benefit even after considering the higher tax on recaptured depreciation.
The only exception is if there is a loss at the time of the sale.
Let’s say you purchased a property for $275,000. Using straight-line depreciation, you would qualify for an annual deduction of $10,000 due to the depreciation expense. If, three years later, you sold the property for $400,000, your tax situation would resemble the following:
Purchase price: $275,000
Depreciation Expense: $30,000
Adjusted costs basis: $245,000
Based on this scenario, the IRS would tax the profits of $125,000 as capital gains (max tax 20%) and the $30,000 as ordinary income. However, if your household tax rate is 37%, you would pay a maximum of 25% of the recaptured amount.
Avoiding Taxes When Selling Real Estate
Another option that could further defer taxes is using a 1031 exchange. The IRS allows you to avoid taxes at the time of the sale if you use the gains to purchase another qualified asset. This strategy could perpetually avoid taxation on the gains achieved on your real estate assets.
If you are interested in learning more about taxes and strategies we use to reduce the amount you pay the IRS through real estate syndications, watch our introductory video.
Note: For those Accredited Investors my McKee ATM Income Fund does not have any depreciation recapture as these Automated Teller Machines are depreciated, including bonus depreciation, over their 7 year useful life then taken out of service and sold for scrap value.