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Recapture Tax – What You Pay for Depreciation

James R Kobzeff

If you sell rental property that you've owned for more than one year prepare to pay back the Feds25% of the depreciation (tax relief) you accumulated during your ownership. It comes from the TaxRelief Act of 1997 and applies to all IRC Section 1250 gains (which for our purposes means allrental property investments) and is generally referred to as “recapture” or Internal Revenue Code(IRC) Section 1250 gain.Here's the idea. Rather then tax your entire recognized gain at the current 15% rate for long-termcapital gains, the taxman figures that depreciation (cost recovery) has already given you tax relief during the holding period of the asset and therefore should be taxed at the higher cost recoveryrecapture rate of 25%. Consequently, thanks to the recapture tax, you pay more taxes when youdispose of your income property.

Example:

Let's say you sell an apartment complex after several years of ownership and realize again of $300,000 of which $100,000 is attributable to accumulated depreciation. How much taxwill you owe? First, you must pay the recapture tax on $100,000 at 25% ($25,000), and then youmust pay the long-term capital gains tax on the remaining $200,000 at 15% ($30,000). You willowe the IRS a total of $55,000.Okay, now do the math without the recapture tax and assume that the entire gain of $300,000 getstaxed at 15%. In this case, you would owe the IRS $45,000. In other words, because of thestatutory tax rate applied at sale to the cost recovery (depreciation), you owe the IRS $10,000 morein taxes then if the recapture tax didn't exist.Here are several other facts about recapture tax in case you're wondering.1.The recapture of depreciation or cost recovery rules don't apply when the property isdisposed of at a loss.2.The amount subject to recapture cannot exceed the gain realized.3.Recapture taxes are paid in addition to and before capital gains taxes and, like capital gainstaxes, can be deferred in a 1031 exchange (which, in fact, is the only way to avoid payingthe recapture tax).The rate of taxation on the cost recovery (i.e., depreciation) portion of capital gain is currently25%, but from time to time is subject to change by the legislature. Therefore, always consult a taxspecialist before you sell rental income property and avoid letting the recapture tax blindside you attax time.