Great question, Lynn. And the short answer is that depreciation recapture doesn't kick in until you realize a financial gain on an asset. So, you won't have to worry about paying the IRS depreciation recapture until you sell the property. But there are some "what ifs" to consider.
Understanding depreciation recapture
One of the main tax benefits available to rental property investors is depreciation. In a nutshell, the IRS allows the initial cost basis of a rental property to be deducted over a period of time -- 27.5 years for residential rental property, to be exact. In other words, if you spend $200,000 on a rental property, you can deduct $7,273 each year to help offset your taxable rental income.
The only problem is that if you sell the rental property at a profit, the IRS wants that back. For example, if you've owned that $200,000 property for 10 years, have deducted a total of $72,730 in depreciation, and then sell the property for $300,000, you'll have a $100,000 taxable capital gain, plus $72,730 in accumulated depreciation that is taxable as ordinary income for most people. The latter portion is known as depreciation recapture.
With most (non-real estate) assets, the concept of depreciation is intended to offset the fact that the asset will generally become less valuable over time. For example, a computer you buy today won't be worth nearly as much in five years. However, as we know, real estate tends to appreciate in value over time, which is why depreciation recapture generally applies when selling a rental property.
Does depreciation recapture apply to you?
Here's a key point that should provide a little more color to the question of "when do I pay depreciation recapture?"
Depreciation recapture is based on the assumption of a profitable sale of the property. So, it doesn't matter when you stop using the property as a rental. It only matters if and when you realize a gain on the sale of the property.
Also, because depreciation recapture assumes you're making a profit on the sale, it doesn't apply in every situation. It only applies when a taxpayer earns a financial gain on a depreciated asset. So, if you originally paid more for the property than you end up selling it for, you might not owe as much in depreciation recapture as you think, or any at all. If this applies to you, I'd strongly suggest consulting with a licensed tax professional, as it can get complicated to report correctly.
One final thing to mention is while you won't need to pay depreciation recapture right away, you are generally required to stop deducting any expenses related to the investment property. (You may already know this, but I want to be thorough.) Once you stop making the property available for rent, the ability to deduct ownership expenses stops as well.
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