It is extremely important that you take depreciation and depreciation recapture issues into account when evaluating the various options available to you for your real estate investment planning. Depreciation issues are important considerations in the real estate investment equation, and can have significant impact on the overall income tax consequences when transacting a 1031 exchange. This article will help you sort through the complex issues of depreciation and depreciation recapture and how they may affect your 1031 exchange transaction.
You are required to deduct or write-off a certain percentage of the cost of the structures and/or improvements on your real property held for rental, investment or use in your business as depreciation expense each year. The depreciation deduction recognizes the decrease in the value of the property caused by wear, tear and usage. Investment real estate is depreciable when it is placed in service; not when acquired. To qualify for depreciation deductions, your tangible or intangible property must:
1. be used in your business, be income-producing, or held as investment property;
2. be property in which you have a capital investment;
3. have a determinable useful life;
4. have an expected life of more than twelve (12) months; and
5. not be excepted property
Property held for personal use, such as a home, second home, vacation home, or automobile, cannot be depreciated since it is not held for investment. Inventory held primarily for sale, including real estate investments, cannot be depreciated. You can depreciate most types of tangible property (except land), such as buildings, machinery, vehicles, furniture, and equipment. You can also depreciate certain intangible property, such as patents, copyrights, and computer software.
You may be required to “recapture” the depreciation deducted by you on your real estate investment property upon the disposition (sale) of the investment property. This means that you may have to recapture or add back into your taxable income the amount of depreciation taken on your investment property when you dispose of (sell) your investment property, unless you take advantage of any number of tax-deferred or tax-exclusion strategies available to you. Depreciation allowed or allowable, whether deducted or not, must be included in the depreciation recapture income tax computation upon the disposition (sale) of your real estate investment.
Income Tax Rates
You are probably already familiar with the current Federal capital gain income tax rates, which vary based on your income tax bracket, for properties held more than 12 months. In most cases, you will find yourself subject to the maximum Federal capital gain income tax rate of 15%. However, you may not know that depreciation recapture is taxed for Federal income tax purposes at a substantially higher flat rate of 25%. You may be subject to state or local income taxes as well, so consult with your tax advisor for more specific and complete information.
Real estate that has been held and depreciated over an extended period of time may be subject to significant depreciation recapture income tax liabilities, and may be a big reason you decide to participate in a 1031 exchange.
Section 1250 Property (Depreciable Real Property)
Generally, real estate investment property, as defined under Section 1250 of the Internal Revenue Code, must be depreciated for income tax purposes. The depreciation method used depends on a number of factors including when the investment property was placed into service, the type of investment property, and the depreciation methods allowed under applicable tax laws and regulations at the time the investment property was placed into service.
But a more complex set of rules comes into play when the asset sold is depreciable real estate. This is so because, in that case, a maximum rate of 25% will apply to what’s called unrecaptured section 1250 gain and a maximum rate of 15% will apply to the balance of the gain. “Unrecaptured section 1250 gain” refers to the portion of gain that is eligible for capital gain treatment even though it is attributable to previously allowable depreciation. A further complication is that the portion of the gain that is unrecaptured section 1250 gain depends, as shown below, on when the property was placed in service.
Property placed in service after 1986. For real estate placed in service after 1986, all depreciation deductions allowable before the sale of the real estate give rise to unrecaptured section 1250 gain. Thus, if you sell, at a gain of $200,000, a building on which $90,000 of depreciation deductions were allowable to you through the time of sale, $90,000 of the gain is unrecaptured section 1250 gain that will be taxed at a rate of 25%. The remaining $110,000 of the gain will be taxed at a rate of 15%. Property placed in service before 1987 and after 1980. For real estate placed in service before 1987, but after 1980 (pre-1987 realty), the treatment of gain on sale depends on whether the real estate is residential or nonresidential.
Residential Real Estate
If you depreciated residential pre-1987 realty using just straight line depreciation, the tax results if you sell it will be the same as for a sale of post-1986 property, as described above. But if (as was possible) you, at any time, used a declining balance method to depreciate the real estate, the gain on sale would be taxed as follows:
Gain to the to the extent of the depreciation claimed that exceeds what would have been allowable under straight-line depreciation, will be recaptured as ordinary income, and, thus, taxed at rates as high as 35% in 2003 and later years (“ordinary income rates”) (but the amount of excess depreciation subject to recapture may be less for certain low-income housing).
gain, to the extent of the depreciation that isn’t recaptured as ordinary income, will be taxed at a rate of 25%. The balance of the gain will be taxed at a rate of 15%.
Example. In January 1986, you paid $1.3 million for an apartment building (not a low-income building), of which $1 million was allocated to the improvements. You depreciated the property using the 175% declining balance method. You sold the property in July 2003 for $2 million. From 1986 through 2003, a total of $915,750 in depreciation was claimed. Assuming the only adjustment to basis was for depreciation, there would be a gain of $1,615,750 ($2 million less remaining basis of $384,250), taxed as follows:
(a) $19,583 (the excess of $915,750 depreciation claimed over $896,167 that would have been allowable using straight-line depreciation) would be taxed as ordinary income;
(b) $896,167 (the depreciation that isn’t recaptured as ordinary income under (a)) would be taxed at a rate of 25%;
(c) $700,000 (total gain less amounts in (a) and (b)) would be taxed at a rate of 15%.
Non-Residential Real Estate
As is the case for residential pre-1987 realty, if you depreciated nonresidential pre-1987 realty using just straight-line depreciation, the tax results if you sell it will be the same as for a sale of post-1986 property, as described above. But if, as was possible, you, at any time, used a declining balance method to depreciate the realty, the gain on sale would be taxed as follows: gain, to the extent of the full amount of depreciation allowable to the time of sale, would be recaptured as ordinary income, and, thus, taxed at ordinary income rates; the balance of the gain would be taxed at a rate of 15%.
Example. Assume the same facts as in the Example above, except that the $1.3 million building is a commercial building. The gain is the same, $1,615,750, but would be taxed as follows:
(a) $915,750 (representing all of the depreciation allowable) would be taxed as ordinary income;
(b) $700,000 (the balance of the gain) would be taxed at a rate of 15%.
Pre-1981 property. The following rules apply if you sell real estate placed in service before 1981: the excess of depreciation claimed over straight-line depreciation is recaptured as ordinary income, and, thus, taxed at ordinary income rates (but the amount of excess depreciation subject to recapture may be less for certain residential real estate or for real estate acquired before 1970) gain, to the extent of the balance of depreciation allowable, is unrecaptured section 1250 gain, taxed at a rate of 25%. The balance of the gain, if any, would be taxed at a rate of 15%.
Exchange for Non-Depreciable Property
When depreciable section 1250 property is exchanged for non-depreciable real property, such as raw land, then excess depreciation and 1250 unrecaptured gain is recaptured and is taxable at the time of the exchange, even though no taxable boot is received in the exchange. This is a tax trap that few taxpayers are aware of.
If you have further questions about the above rules please consult your CPA. Planning ahead is good practice that can potentially save you a ton of money.
Wai-Yew Lam, President
TREC Certified Instructor