Investing in rental properties can be a rewarding venture, as this investment option offers a potential source of passive income and long-term wealth accumulation. One important aspect of managing rental properties, though, is dealing with depreciation. While depreciation can provide tax benefits to property owners, there is often confusion about whether or not these deductions need to be paid back when a piece of property is sold. In this article, we’ll explore the concept of depreciation on a rental property, and delve into what depreciation recapture is and how it works.
What is Depreciation on a Rental Property?
The term “depreciation” refers to a tax benefit that allows a property owner to deduct some of the cost of their property over a span of time. When it comes to rental properties, depreciation includes the structure on the property (the home). Land, being determined a non-depreciable asset, is not included when determining depreciation on a rental property.
As of 2020, the IRS states that a residential rental property has a useful life of 27.5 years when using the General Depreciation System. This means that over that period of time, the property gradually wears out or depreciates. As such, real estate investors who own rental properties can often deduct 3.636% of the cost of their property from their annual income each year to reduce their taxable income.
How Does It Work?
Several things need to be taken into account when it comes to claiming depreciation on a rental property. For example, in order for you to claim depreciation on a rental property, the following criteria have to be met:
- You own the property in question
- The property is being used as a business or an income-producing activity
- The property has a determinable useful life
- The property is expected to last for more than one year
If your property qualifies, you may begin claiming depreciation deductions as soon as you place the property in service. Placing the property in service means it’s ready and available to be used as a rental home for your tenants.
Once you begin claiming depreciation deductions on your property, you can continue doing so until you have either deducted your entire cost or you retire the property from service. Retiring a property means that you no longer use it as an income-generating property. This includes selling the property, converting it to personal use, and abandoning or destroying it.
Do You Have to Pay Back Depreciation?
Many real estate investors wonder whether they have to pay back depreciation deductions if they decide to sell their rental properties.
The short answer is that depreciation on a rental property doesn’t need to be paid back in a literal sense. Because depreciation is considered a non-cash expense, it doesn’t involve any actual expenses out-of-pocket. Instead, this tax option simply allows property owners to account for the gradual loss of value that their properties will incur over a determined length of time.
However, there’s an important consideration to keep in mind when it comes to depreciation, and that’s depreciation recapture tax. Though depreciation itself doesn’t require former property owners to pay back their deductions, the IRS does have plans in place that are designed to recapture a portion of the property’s previously claimed depreciation upon its sale.
What is Depreciation Recapture Tax?
Depreciation recapture tax refers to a process that takes place if you sell a rental property for a profit. In this scenario, the IRS may recapture a portion of the depreciation that you claimed during the time that you owned the property.
After selling a rental property, real estate investors would use IRS Form 4797 to report depreciation recapture as well as the total gain or profit from the sale of the property.
This means that the total depreciation expense the investor took to reduce their taxable net income is then recaptured by the IRS and taxed at the investor’s ordinary income tax rate. This could be up to the maximum rate of 25%.
How to Avoid Depreciation Recapture Tax
There are a couple of strategies an investor might attempt in order to minimize their tax liability when it comes to depreciation on a rental property. However, it’s important to note that tax laws are complicated, and whether each option is applicable or not depends on individual circumstances. Before attempting any strategy to minimize your depreciation recapture tax, it’s essential to consult with a qualified tax professional or financial advisor to ensure that your plans are in compliance with current tax laws and regulations.
1031 Exchange
Under Section 1031 of the IRS code, investors can defer the recognition of gain (and delay depreciation recapture tax) by reinvesting the proceeds from the sale of real estate into the purchase of a similar property. This method is also known as a like-kind exchange.
Section 121 Exclusion
Section 121 exclusions allow property owners to exclude up to $250,000 ($500,000 if married and filing jointly) of capital gains from their home sale. This exclusion can also significantly lower one’s depreciation recapture tax. Investors may qualify for this exemption if they live in the home they’re selling for at least two of the five years before the property’s sale.
Understanding the implications of recapture tax is essential for property owners who plan to sell rental properties. Depreciation on a rental property remains a valuable tool for maximizing tax benefits during ownership of the property, but it’s important to be aware of the potential tax implications that can occur when you decide to sell. Working with a tax professional can help you navigate the complexities of depreciation and ensure you make informed decisions when it comes to your investments.
