Here’s an example. Say you hold the rental property you bought for $240,000 for 10 years and you’ve written off $74,130 in depreciation deductions. That's $5,409.60 for the first year, since it was placed in service in April, and $7,635.60 each year for the remaining nine years.
In this example, your adjusted cost basis in the property after 10 years is $135,870 (the original cost basis of $210,000 less the $74,130 depreciation). If you sell for, say, $300,000, you’ll recognize a gain of $164,130 ($300,000 minus $135,870).
While it would be nice to pay taxes at the lower capital gains rate on the entire gain, you’ll pay up to 25% (based on your ordinary tax rate) on the part that’s tied to depreciation deductions. If you owe the maximum, it would be 25% of $74,130, or $18,532.50.
The remaining $90,000 is taxed at your regular long-term capital gains tax rate. Assuming you’re in the top bracket, that would be $18,000 in capital gains taxes. All in all, you’re looking at $36,532.50 in taxes.
Depreciation recapture applies to the lesser of the gain or your depreciation deductions. If you sell the property for $200,000, for example, you’ll have a gain of $64,130. Since that’s less than the $74,130 depreciation deductions you’ve taken, the recapture rate of 25% applies to the entire $64,130 gain for a total tax bill of $16,032.50.
Depreciation recapture when selling a rental property for a loss
Depreciation recapture doesn’t apply if you sell for a loss. Assume the real estate market is tanking and you sell for $100,000. In this case, no depreciation recapture is required; instead, you would report a loss of $35,870.
While this looks like a big loss, remember that you’ve already benefited from $74,130 in depreciation deductions over the previous 10 years. So your investment comes out with a gain of just over $38,000.
Provided you owned the property for more than a year, the loss is considered a Section 1231 loss, which means it can be used to reduce your tax liability during the tax year. You can also carry back the loss to offset the previous two years of taxable income, though you’ll have to refile those tax returns. Or you can carry it forward to offset future income for up to 20 years.
Find a good tax professional
Keep in mind that these examples are overly simplified. Also, rental property tax laws are complicated and change periodically. Unless you're a real estate tax law rock star, you should work with someone who is. Find a qualified tax accountant when you establish, operate, and sell a rental property. That way you’ll receive the most favorable tax treatment possible and avoid any surprises at tax time.