The majority of investors own rental properties in order to generate income. They frequently provide income as long as you can keep them busy. Also, the value of the home can increase, giving you a tidy profit when you decide to sell.

But you need to know what happens when you sell a rental property before you sell the property. Understanding depreciation recapture taxes is crucial because they frequently catch investors off guard in the last minute.

A tax on the depreciation you deducted while owning the property is known as depreciation recapture tax. Uncle Sam will want a percentage of the proceeds from the sale of the property that you deducted from your income.

Depreciation For A Rental Property: What Is It?

Even if the rental property's value rises, you can still deduct depreciation as a real estate investor. Depreciation only exists on paper, and it only applies to the IRS. Only the building may be depreciated; the land cannot.

The land represents 20% of the home's value on average, but for exact figures, consult your most recent assessment or tax bill. The value of the land and buildings varies for each property. Your depreciation cost basis is 80% of the purchase price, or $160,000, for instance, if you purchased a home for $200,000 and the tax bill indicates that the land is 20% of the value of the home. The land's worth of $40,000 cannot be depreciated.

As soon as you "put it in service," you are able to depreciate the property. You can't begin depreciating a house until January 1 or the day you put it in service if you acquire it on June 1 and take six months to spruce it up and advertise it as being available. Whether or not you have renters, this date is still relevant as long as the property is listed for rent.

Throughout the course of the property's useful life, which the IRS estimates to be 27.5 years or 3.63% of the cost basis annually, you depreciate the house. Your cost basis is the purchase price of the house less the value of the land and any renovations that increase the home's value. Nevertheless, you cannot include the price of obtaining a loan, rent paid in advance of closing, or fire insurance premiums.

Depreciation Recapture: What Is It?

Your tax obligation is reduced by the depreciation deduction each year that you own an investment property. It is a tax deduction. Depreciation recapture tax, however, will be due when you sell the asset.

On whatever depreciation you claimed, you will be responsible for paying the lesser of your existing tax bracket or 25% plus state income tax. The real sting is that even if you didn't deduct the expense for depreciation, you'll still be responsible for paying depreciation recapture tax, so be sure to do so when you can.

Depreciation recapture tax is only not due if you sell your house at a loss. Consider a scenario in which you can no longer afford to maintain the home due to a sharp decline in the market. You cut your losses and sell for as much as you can, but less than what you originally spent. You don't owe a recapture tax since you report a loss on your taxes.

It's Not As Complicated As You Think: Depreciation Recapture Tax

You are liable for depreciation recapture tax if you sell the asset for more than you paid for it.

Simply multiply the total amount of depreciation claimed over the time you owned the property by your ordinary income tax rate to determine this amount.

Depreciation recapture tax would be $7,200 ($40,000 * 18%) if you owned the property for 10 years, claimed $40,000 in depreciation during that time, and paid income tax at an 18% rate.

Example of Depreciation Recapture

Let's say you paid $200,000 for a rental property, claimed a total depreciation of $55,000 over ten years, and later sold it for $240,000. Let's now analyze the data in a format that is rather straightforward.

Initial Purchase Price of the Rental Property: $200,000

Depreciation claimed overall for a ten-year period: $55,000

$160,000 is the original cost basis.

Step 1: Exercise The Tax Amount for Recapture of Depreciation on Rental Property

The whole amount of depreciation ($55,000) is simply multiplied by 20% if your ordinary income tax rate is 20%.

20% income tax rate

$55,000 in total depreciation

Recapture Tax on Depreciation = $55,000 * 20%

$11,000 is the Depreciation Recapture Tax.

Calculate the Capital Gains Tax Amount in Step 2

The property's modified cost basis is crucial at this point. That directly affects the overall capital gain.

$160,000 is the original cost basis.

Relative Cost Basis: Total Degradation - Original Cost Basis

Cost Basis Modified: $160,000 - $55,000

Rental property sales price minus adjusted cost basis equals capital gain.

$135,000 is the capital gain.

Amount to be Paid in Capital Gains = $135,000 * 15%

$20,250 is the capital gains tax amount.

Step 3: Sum these two figures to determine the total amount of tax due.

Depreciation recapture tax plus capital gains tax equals total tax payable.

Taxes due in total equal $11,000 plus $20,250.

Taxes Due in Full: $31,250

What percentage is depreciation recapture tax, and what percentage is capital gains tax?

The entire amount of depreciation you claimed during the time you owned the property, along with your personal income tax rate, determine the depreciation recapture amount.

The appropriate capital gains tax rate is applied to the remaining "gain."

Your long-term capital gains tax rate, assuming you own the property for more than a year, will range between 0% and 20%, depending on the size of the capital gain and your marital status.

According to how much money you make when you sell the rental property, the chart below breaks out how to calculate the capital gains percentage.

Capital Gains Tax Rate Chart for Rental Properties Tax Filing Status: Single Married Filing Joint

marital status, filing separately

Head of the family

0%

$0 to $40,400

$0 to $80,800

$0 to $40,400

$0 to $54,100

15%

$40,401 to $445,850

$80,801 to $501,600

$40,401 to $250,800

$54,101 to $473,750 \s20%

$445,851 and upwards

$501,601 and upwards

$473,751 or more and not $250,801

IRS Depreciation Regulations

Whose depreciation of a rental property does the IRS assume? The house is eligible if it complies with the conditions listed below:

Whether you have a mortgage on the house or own it completely.

You own the house because it's a part of your business, so you rent it out.

The item has a minimum one-year usable life.

A rental property cannot be depreciated or subject to depreciation recapture tax if it is purchased and sold in the same calendar year.

Final Reflections

Depreciating your rental property increases your cash flow while you possess it and puts off paying taxes until you sell it. It's comparable to an interest-free loan, but keep in mind the taxes. Due to the taxes you'll incur, your profit when you sell the home will be lesser. Even if you don't take the deductions, you can't avoid it, so make the most of them while you can and consider your tax burden when choosing the asking price for the house.