Many investors forget to consider the effect of Depreciation Recapture Tax when an investment property is sold.

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Financial gurus point out that rental real estate investments are very popular because the investor gets to enjoy the receipt of positive cash flows, obtain certain tax deductions and build up equity, and allow the investor’s property to appreciate in value over time. BUT what happens when you want to sell that investment property? The answer is that you get hit with a number of different taxes.  

A major reason smart investors execute a Section 1031 exchange, with Affiliated 1031 acting as the Qualified Intermediary, is that the taxpayer wants to defer paying any of the taxes mentioned above.

The 3 Typical Taxes When Selling Real Estate

Generally, there are three different taxes that a real estate investor could be subject to when selling the investment real estate.  The three (3) probable taxes are (1) Long-term Capital Gains Taxes, (2) State or Municipal Taxes, and (3) Depreciation Recapture Tax.

Capital Gains Tax

For this missive’s purposes, we are defining an investment as a piece of real estate that has been owned for more than one year.  Investments owned for a shorter period are taxed and classified as Short-term Capital Gains.  These Short-term Capital Gains are treated as regular income and taxed based on the individual’s federal tax rate.

Long-term Capital Gains Taxes are levied on those investments held for more than a year and are taxed at a lower rate than Short Term Capital Gains Taxes. 

In 2021, individuals whose taxable income is $40,400 or less did not even pay Long-term Capital Gains Taxes. 

However, if that individual’s taxable income is $40,401 to $445,850.00, the investor must pay a 15% Long-term Capital Gains Tax.  If that investor’s taxable income is above $444,850, then their Long-term Capital Gains Tax rises to 20%.

State Income Tax

In addition to Long-term Capital Gains Taxes, most States charge an income tax—The amount of the tax varies from State to State.  As of today, nine states, in one form or another, do NOT have a State Income Tax; they are Alaska, Florida, Nevada, New Hampshire (but it does tax investment earnings), South Dakota, Tennessee, Texas, Washington, and Wyoming.

Depreciation Recapture Tax

So, what is the Depreciation Recapture Tax?  Depreciation Recapture is a tax on the portion of the taxpayer’s gain attributable to the amount of the depreciation the taxpayer took or should have taken on the investment property. Under the current IRS Code, investment real estate can be depreciated over 39 years for commercial property and depreciated over 27.5 years for residential investment property. What does that mean?  My son explained it this way:  IRS says your investment is falling apart or in need of repairs (EXCLUDING THE VALUE OF THE LAND), and as a result, IRS lets you take a deduction on your income tax return of 1/27.5th a year for residential investment real estate and 1/39th a year for commercial real estate.  The IRS Code, Section  167 (a),  infers that your real estate investment is not worth as much each year due to exhaustion, wear and tear, and obsolescence.

An Example

Let me give you a simple example of Depreciation and how it is used for tax purposes.

An investor purchased a Condominium for $325,000, which is being used as an investment, not for the investor’s own personal use.

Assuming that the land value is $50,000 (land cannot be depreciated), the investor will be left with $275,000 for depreciation purposes ($325,000 – $50,000(land)  = $275,000).

For income tax purposes, by taking the depreciation deduction, the investor can reduce their net taxable income by $10,000 a year ($275,000 divided by 27.5 years equals $10,000 a year).

You can understand why most investors love this tax benefit.

Here comes that big word again—BUT– what happens when the taxpayer decides to sell that investment property?

The taxpayer will be taxed Long Term Capital Gains Taxes, State Taxes where applicable, AND a Depreciation Recapture Tax.

The Depreciation Recapture Tax is generally taxed as “ordinary income” and up to a maximum rate of 25%. Some tax experts have also called it “accumulated depreciation.”

One of Affiliated 1031’s exchange coordinators said:  “The government giveth, and then they taketh away.”

That’s a good assessment because first, the taxpayer gets to take a “tax write-off” for depreciation, and then when they sell the investment property, the investor is then taxed on that “tax write-off.”

A lot of taxpayers are not aware of this “Forgotten Tax.” A major reason smart investors execute a Section 1031 exchange, with Affiliated 1031 acting as the Qualified Intermediary, is that the taxpayer wants to defer paying any of the taxes mentioned above.

Most financial advisors describe this as excellent tax planning. Information contained in this information missive should not be construed as tax advice or a promise of potential tax savings or reduced tax liability. 

Affiliated 1031, LLC always recommends that taxpayers consult their tax and/or legal counsel on all matters dealing with the Internal Revenue Service.

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