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Real Estate Investment Software Blog

If you’re about to sell a rental property you’ve owned for more than one year* then you should prepare to pay the Feds a depreciation recapture tax*.

*Depreciation recapture tax occurs when depreciable real estate is sold after one year of ownership. Property sold one year or less is classified as a short-term gain and gets taxed as ordinary income so it’s irrelevant. Recapture tax only applies to a property held for more than one year.

Here’s how it works. When you sell an income property and have a recognized gain, the feds will tax you for the accumulated depreciation you’ve taken during the years you owned the property. In other words, because you were able to reduce your tax liability due to property depreciation (i.e., as a tax shelter), the Feds want you to pay some of it back now that you’re selling the investment property. (the recapture tax is currently 25%).

For example, if you realize a gain of $300,000 of which $100,000 is attributable to depreciation, your taxes might compute this way:

1. Your accumulated depreciation of $100,000 gets taxed at 25%. Hence, you owe $25,000 recapture tax.
2. The $200,000 remainder (300,000 - 100,000 = 200,000) gets taxed at 15% (the current capital gains tax rate). Hence, you owe $30,000 capital gains tax.
3. Your tax obligation for real estate capital gains totals: 25,000 plus 30,000. Hence, you owe $55,000.

Now suppose you had no knowledge of depreciation recapture tax. You would probably assume when you sell that your full gain will be taxed as capital gains. In your mind, the full $300,000 gain gets taxed at 15%, and thereby conclude that you owe the IRS $45,000. Imagine the shock when you learn that you owe $55,000; a whopping $10,000 more tax than expected; hence, $10,000 less proceeds than expected (say goodbye to the wide-screen television).

The bottom line? Real estate investing requires sound real estate investment tax strategies. So you should always consult a tax specialist before you sell rental income property, and maybe think about investing in a good real estate investment software program. It might keep you from getting blindsided at tax time, and likewise prevent unrealistic expectations that result in an unpleasant disappointment later.