Depreciation recapture is a tax provision in the United States (a federal tax law) that imposes an additional tax on real estate sales. The Depreciation Recapture Tax applies to both buyers and sellers of real estate that is, whosoever happens to invest in the property.
The idea behind the tax is that by selling a property, one would receive some "depreciated value", which can be used to lower one's overall taxable income during future years. In order for this depreciation feature to be successful, ownership of a property must have been held for more than six years.
This article aims to provide answers as well as questions on depreciation recapture, all while addressing common misconceptions and answering commonly asked questions related to this issue.
Defining terms in a basic real estate context
Depreciation: Depreciation is the decrease in the value of an asset (such as a house) due to wear and tear age, or obsolescence. The US Internal Revenue Service (IRS) allows taxpayers to write off property depreciation over 36 to 42 years. This is known as a "Recapture".
Depreciation Recapture: When the IRS recaptures (or takes back) the depreciation amount that they gave you during the life of your asset, it is referred to as Depreciation Recapture.
Why do you care? When a property owner sells their property, the IRS requires that he or she declare any depreciation as taxable income. Additionally, you have to calculate the depreciation recapture in order to determine how much of your gain is taxable. In other words, if you purchased a property for $500,000 and sold it 10 years later at $650,000, you will have depreciated approximately 39% of your purchase price over that time period. This means that when your property is sold for $650,000 (before transaction costs), the IRS will consider taxation on $120,000 worth of equity (the depreciation amount).
As mentioned above, depreciation recapture can be extremely confusing for many people. In fact, the IRS has a Tax Topic for depreciation recapture that goes over just how this process works. Below are some of the most commonly asked questions related to Depreciation Recapture.
What is deprecation? Deprecation is a deduction that can be used to offset your taxable income in order to save money on your taxes. As mentioned above, you get depreciation by using up or wearing out an item during its useful life. For example, if you lived in your house for 10 years and only got 5 years’ worth of use out of it instead of the full 15 year life expectancy, you would have depreciated 10/15ths (or 66%) of its value by the end of the 10th year. Depreciation occurs when you buy an item that is going to last a long time.
What is the purpose of depreciation?
The IRS allows you to write off depreciation in order to help offset your taxes. Depreciation can lower your tax burden both in the year that a depreciable asset is purchased and when it's sold. However, the IRS only allows you to claim depreciation in years where there is wear and tear on an item or physical deterioration. Merely owning property for more than one year does not allow you to claim depreciation.
Why do you care? There are a few different ways to calculate depreciation, and the IRS allows taxpayers to choose which method to use based on how they want to calculate their taxes. The two most common ways to calculate your depreciation are: "Straight Line" and "Sum of the Years". To determine how much you depreciate, you must first determine what value was deducted or "depreciated" during the year and divide it by the number of years that that item was depreciated.
For example, if you bought a new 5-Year car with a car loan for $20,000.00, and got 10/15ths (or 66%) of its value in depreciation in the first year through wear and tear, what was it worth after the first year?
To use the "Straight Line" method to calculate depreciation, one must subtract your basis from the current sales price. Suppose that one needs to depreciate an automobile (a 5-year old car) that was purchased for $20,000. There is no need to determine what basis this car had due to the very limited time that it was owned by the taxpayer (even though its value decreased over time). All you have to do is subtract $20,000 from the current sales price of that car which is $15,000.
The current value after one year is calculated as follows:
$ 15,000 original car price minus $ 20,000 car purchase price equals $ 5,000 depreciation after one year. Then we divide by five years: $ 5,000 divided by 5 years (same as 1/5) equals the depreciated value of the car after one year. As you can see in the above example, this is the same as saying that one car was worth $5,000 after its first year. This is referred to as a "Straight Line" computation of depreciation.
The "Sum of the Years'' method allows taxpayers to more accurately calculate their depreciation since the first year does not need to be discounted (as a "Straight Line" calculation does). By taking all the years of depreciation and adding it up, many taxpayers are able to accurately determine their depreciation value after one year. Suppose that one needs to depreciate an automobile (a 5-year old car) that was purchased for $20,000. One would first write down the value of the car after one year using the "Straight Line" method, then add up all other years for which the taxpayer had to depreciate and divide by five. This is known as a "Sum of the Years'' calculation of depreciation. After one year, this value would be: $20,000 car purchase price minus $5,000 depreciation equals $17,000 value after one year. Then we would need to add all other years of depreciation that needed to be depreciated for this example. There are five years total. $20,000 car purchase price minus $13,000 depreciation equals $7,000 value after 5 years. $17,000 + $7,000 = $24,000 total dollars of depreciated value after 5 years.
**Then we divide by five: ** $24,000 divided by 5 equals the depreciated value of the car after one year. Then we would need to add all other years of depreciation that needed to be depreciated for this example. There are five years total. $20,000 car purchase price minus $13,000 depreciation equals $7,000 value after 5 years. $24,000 + $7,000 = $31,000 total dollars of depreciated value after 5 years.
Using the "Sum of the Years" method to calculate depreciation actually allows everyone to see how much is really being depreciated in a given year. This can make it more clear for the average person who does not have a great understanding of depreciation. Using the "Straight Line" method is only for those who have a greater understanding of how depreciation is calculated and calculate their taxes that way.
What is depreciation recapture?
Depreciation recapture is the term used when an owner of the property that was depreciated must pay taxes on it when it was sold. The IRS requires taxpayers to use this method for all assets that are sold or exchanged during a year in which the taxpayer did not pay the entire amount that they had depreciated. You have to pay taxes on any unused depreciation in one of three ways: If these taxes cause you to owe only a small amount, you can send in what you owe with your tax return. However, most taxpayers still owe cash at the end of the year and will need to make a deposit using Form 8824.
To conclude, this is all about depreciation recapture that you need to know when you are looking to invest in a property. Though if you want to make sure that you do not commit any errors or mistakes, then you can consider getting help from the best i.e. Better Capital, and ensure that you make the best out of your investments.
For more information, you can visit Real Estate Calculators.
