While the tax consequences of the sale of real estate should not drive the decision to sell or hold a property, there are important issues to consider in order to make informed decisions. One aspect relates to the applicable tax rates of a long-term capital gain resulting from the sale of real property.
To recap the basics, upon the acquisition of a property the cost of the building and land are capitalized. If the building is a rental property or used in a trade or business, the cost attributable to the building is depreciated over 27.5 years (residential) or 39 years (non-residential) using the straight-line method for tax purposes. Land is non-depreciable therefore, no depreciation is permitted. In summary, the cost of the building is written off ratably over the life of the asset via annual depreciation deductions.
Depreciation deductions offer the property owner the tax benefit of a deduction at their personal ordinary income tax rates. Additionally, depreciation deductions reduce the cost basis of the property which ultimately determines the gain or loss upon the sale or disposition of the property. If sold as a long-term gain, under current tax laws, long-term capital gains tax rates range between 0% – 20% depending on the taxpayer’s level of income.
However, not all gains benefit from the long-term capital gain tax rates. Depreciation recapture is the portion of the gain attributable to the depreciation deductions previously allowed during the period the taxpayer owned the property. The depreciation recapture rate on this portion of the gain is 25%. The reasoning behind the depreciation recapture rules is since the taxpayer received the benefit of a depreciation deduction that offset ordinary income tax rates (a potential Federal tax savings of up to 39.6%), the government is not going to grant the most favorable capital gains rates on the portion of the gain relating to these prior depreciation deductions. The following examples illustrate the concept of depreciation recapture.
Assume a property owner acquired a building for $2 million (excluding land). Assume after 10 years the owner has taken $500,000 of depreciation deductions. The owner’s basis in the building is now $1.5 million. If the owner sells the building for $5 million, they will recognize a gain of $3.5 million ($5 million less $1.5 million). It is often presumed the $3.5 million would be taxed at a capital gain rate of 20%. However, in this example, $500,000 of the gain would be taxed at the recapture rate of 25%. The remaining $3 million gain would be taxed at the 20% capital gain rate. The outcome in this example is an additional $25,000 tax cost (5% on $500,000). Larger transactions would obviously have larger implications.
Depreciation recapture is limited to the lesser of the gain or, the depreciation previously taken. Using the example above, assume the owner sells the building for $1.6 million resulting in a gain of only $100,000. Since the $100,000 gain is less than the $500,000 of depreciation deductions the recapture rate of 25% would apply to the entire $100,000 gain.
In the event a property is sold at a loss the depreciation recapture rules do not apply. Assume in the above example the property was sold for $1.1 million. The property owner would simply report a loss of $400,000. No depreciation recapture calculations would be required.
The 25% depreciation recapture tax rate only applies to the portion of the gain attributable to real property. If a sales contract includes the sale of other assets, such as furniture and equipment, the gain relating to depreciation recapture on those assets would be taxed at the property owner’s ordinary income tax rates.
As with any transaction or tax planning, it’s important to consult with your tax adviser to obtain an understanding of tax implications in order to make proper and informed decisions.