For example, let’s say I acquired a rental property in August 2019 with a building cost basis of $100,000. Based on the percentage in the chart above, I can take a depreciation deduction of $1,364 on my 2019 tax return to offset whatever rental income the property generated. In subsequent years, I can take the full depreciation amount, or $3,636.
If you sell a property, the depreciation is prorated in the opposite manner (largest percentage in December, smallest in January). And remember that your depreciation deductions end after your entire cost basis has been depreciated. For example, if I own an investment property with a $100,000 cost basis and I’ve already depreciated $99,000 over the years I’ve owned it, I can only use a $1,000 depreciation deduction for this year. Then I can no longer claim the benefit on my subsequent tax returns.
Depreciation recapture: How real estate depreciation affects you when you sell
Remember that real estate depreciation lowers your cost basis over time. This can have major tax implications when you eventually sell the property. Especially if you sell it for more than you paid for it.
Real estate depreciation, as we’ve seen, can dramatically reduce your taxable rental income every year. That’s why it’s such a great benefit for real estate investors.
However, there’s a big caveat. When you sell a depreciated rental property, the IRS wants this benefit back. This is a form of capital gains tax known as depreciation recapture. While real estate depreciation can be a rental property investor’s best friend, depreciation recapture can be their worst nightmare, especially if they've owned the property for a long time.
Here’s the general idea. When you sell a property, any capital gain -- the difference between the net sale price and your cost basis -- is divided into two parts. Any part that represents a gain over your original cost basis is a capital gain and is taxed at your capital gains tax rate.
Any portion of the sale proceeds that represents a gain over the depreciated cost basis (but not greater than the original cost basis) is depreciation income. That's taxed as depreciation recapture, which currently has a flat 25% rate.
It's also worth mentioning that this applies to the depreciation you were entitled to, whether you claimed it on your taxes or not. You can't forego your annual depreciation deductions and avoid paying depreciation recapture when you sell.
Technically, this applies to any depreciated asset you sell, but in practice, it only affects real estate, as it’s a special type of depreciable asset. Think of it this way -- if you buy a new computer for work and sell it four years later, you’re not likely to get anything close to what you paid. In fact, you’re not even likely to recoup your depreciated cost basis in the asset. On the other hand, real estate tends to increase in value over time.
An example of depreciation recapture
Let’s say you bought an investment property for a net cost (building) of $200,000 and that you’ve owned it for 10 years. You’d have claimed depreciation of $72,727 over your ownership period, which would bring your cost basis down to $127,273.
You now decide to sell the property for net proceeds of $300,000. Of this, $100,000 would be considered a long-term capital gain and would be taxable at your marginal long-term capital gains tax rate -- 0%, 15%, or 20%, depending on your taxable income. The $72,727 of cumulative depreciation would be taxed at a 25% rate. Assuming you’re in the 15% long-term capital gains tax bracket (it's most common), you’d be looking at a $33,182 tax bill on the sale of your property.
A 1031 exchange can help you avoid depreciation recapture
Depreciation recapture can result in a massive tax bill when you sell an investment property. Fortunately, there’s a way to get around it.
If you plan to use the proceeds from the sale of an investment property to buy another investment property, you can use a 1031 exchange to roll the tax liability into the new property’s cost basis. Be sure to check out our 1031 exchange guide if you want to learn more. For now, just know that as long as you keep your money invested in rental properties, you can theoretically defer taxation -- both capital gains and depreciation recapture -- as long as you want.
Calculating your depreciation deduction each year
It would be nice if you could take your cost basis in a rental property, divide it by 27.5, and deduct this amount forever. Unfortunately, it’s not that simple. For starters, you won’t get a full year’s depreciation deduction in the year you acquire the property. Furthermore, you’ll rarely hold a property for 27.5 years without it needing some sort of capital improvement.
With that in mind, consider the following situation:
You acquired a property in February 2019 and the net purchase price was $250,000. Based on your most recent tax assessment, the building makes up 80% of the property value, giving you an initial cost basis of $200,000. In 2021, you renovate the kitchen and bathrooms at a total cost of $40,000. You don’t plan on making any other capital improvements through at least 2023.
So, over the first five years of ownership, your depreciation deductions would look like this: