How Depreciation Affects Real Estate Rental Operators: Operations and Property Sales

Most rental real estate operators are aware of the tax advantages of getting involved with rental real estate. A large part of these advantages suround the ability to take depreciation expense over the lifetime of the asset. However, most operators are not aware of the implications when it comes time to selling property and what it means to your overall tax situation.

Operational Impact: Depreciation as a Tax Shield

Depreciation allows rental property owners to deduct a portion of the property's cost each year, even though the actual cash outlay occurred when the property was purchased. This "paper expense" reduces taxable income, thereby lowering the operator's annual tax liability.

For residential rental properties, the IRS allows depreciation over 27.5 years using the straight-line method. This period is even longer for commercial properties.

For investors, depending on the classification of some additions to the property, they can take additional depreciation, either through bonus depreciation or accelerated methods.

This deduction can offset rental income, sometimes even creating a paper loss that reduces the owner’s overall taxable income, which becomes a strategy that is particularly advantageous for high-income investors or those who qualify as real estate professionals.

Impact at Sale: Depreciation Recapture

When a rental property is sold, the IRS requires owners to "recapture" the depreciation that was previously deducted. There are multiple recapture methods available to the IRS depending on the classification of the property or improvements.

For example, if an investor claimed 100% bonus depreciation on improvement property in a residential rental that cost $27,500, then proceeded to sell the property after 3 years for $30,000, a portion of the sale price becomes a section 1250 gain because the investor took more depreciation than straight-line depreciation allows. See a calculation of the gain below.

The section 1250 gain is taxed at a maximum 25% tax rate, which is higher than a normal 1231 long-term capital gains.

This increase in liability can come as a surprise for taxpayers if they have not adequently planned in advance. It's important that tax considerations be taken into account before making any moves, especially depending on the size of the sale.

Strategies to Manage Depreciation Recapture

Several strategies can help mitigate the impact of depreciation recapture:

• 1031 Exchange: If you sell the property, then roll forwrad the cash from the sale into a "Like-kind property", investors are able to defer not only the depreciation recapture, but the capital gains as well.

• Installment Sales: Spreading out gain recognition over several years based upon receiving a steady payment over a period of time.

• Estate Planning: Holding the property until death or contributing the property to a charitable trust can eliminate depreciation recapture, as heirs receive a step-up in basis, and the trust doesn't pay any taxes when it sells the property.

Conclusion

Depreciation provides meaningful tax benefits during the ownership phase of rental real estate, but it also creates tax obligations when the property is sold. Understanding how to manage both sides of the equation is critical.

A knowledgeable accounting advisor can help you make the most of depreciation while minimizing its long-term tax consequences. If you need guidance navigating depreciation, recapture, or planning for a sale, our team is here to help.