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PROAPOD
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How Rental Property Depreciation and Recapture Tax Works
 James R Kobzeff 
One of the true benefits of owning rental income property is that real estate investors candepreciate the property and enjoy the positive cash flow resulting from writing off the taxdepreciation—just one of the tax shelter benefits associated with real estate investing.Here's how it works.The tax code assumes that the investment property buildings (not the land) are wearing out over time and therefore becoming less valuable. As a result, they permit income property owners totake a deduction for that presumed decline through the depreciation deduction (or cost recovery asit's now called in the tax code) which in turn helps the investor shelter rental income that is subjectto “ordinary income” rates.Assume, for example, that you purchase a multifamily property for $500,000 of which $400,000 isattributable to the buildings (the remaining portion is land value). The IRS assumes a life of 27.5years for residential property (39 years for non-residential) and therefore allows investors to takean annual depreciation deduction of about $14,544 ($400,000 / 27.5). Except in the first year andselling year, 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 noncashdeduction—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 depreciationdeduction 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.On the flip side, because the depreciation taken reduces our investment property’s tax basis andeffectively increases our tax gain when we later sell, if the property is later sold at a gain, the IRSassumes that our gain in part may have resulted from the depreciation we took and in turn imposesa recapture tax on the gain attributable to depreciation taken (imposed at 25% in the Taxpayer Relief Act of 1997, but subject to change so always consult your tax advisor).Okay, let's look back on our previous example and assume that you sell your multifamily propertyat a gain greater than your accumulated tax depreciation (which we'll say is $144,232). Since your gain is greater than your tax depreciation, the recapture rule will apply. As a result, your tax onsale will include the recapture tax of $36,508 ($144,232 x .25) plus a capital gains tax on the
©2009 James R Kobzeff. All rights reserved.
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