Here's how it works.



The tax code assumes that the buildings associated with the rental property (not the land) are wearing out over time and therefore becoming less valuable. As a result, they permit income property owners to take a deduction for that presumed decline through the depreciation deduction (or cost recovery as it's now called in the tax code) which in turn helps the investor shelter rental income that is subject to "ordinary income" rates.

Let's assume, for example, that you purchase a multifamily property for $500,000 of which $400,000 is attributable to the buildings (the remaining portion is land value). The IRS assumes a life of 27.5 years for residential property (39 years for non-residential) and therefore allows investors to take an annual depreciation deduction of about $14,544 ($400,000 / 27.5) except in the first and selling years, which is slightly less ($13,940) due to what is termed the mid-month convention.

The boon for real estate investors, of course, is that the depreciation deduction is a non-cash deduction—it is not an operating expense, therefore you can take it without having to write a check for it as you would other costs associated with running the property. Moreover, if the depreciation deduction is large enough to exceed the property's income, investors can use it to offset other investment income and therein reduce other tax liabilities as well.

Okay, that's the good news.

The bad news is that the Feds want some of that depreciation back. Because the depreciation taken reduces our investment property's tax basis and effectively increases our tax gain, if the property is later sold at a gain the IRS assumes that our gain in part may have resulted from the depreciation we took and hence imposes a recapture tax on the gain attributable to depreciation taken (currently imposed at 25% but subject to change, so always consult your tax advisor).

Okay, let's look back on our previous example.

Assume that you sell your multifamily property in three years at a gain greater than your accumulated tax depreciation (say the gain is $81,684 and the depreciation taken is $42,424). Since your gain is greater than your tax depreciation, the recapture rule will apply.

As a result, your tax on sale will include a capital gains tax on the adjusted net capital gain of $39,260 ($81,684 less 42,424) plus a recapture tax of $10,606 ($42,424 x .25). In other words, it's a one-two punch: Capital gains tax and recapture tax.

The lesson here that you should always account for depreciation recapture tax when performing your real estate analysis on potential investment opportunities. Otherwise, you might be unpleasantly surprised when you sell your property to discover that you owe the IRS more taxes than you where expecting, and that would not be good.