Realty Articles

Are You Prepared to Pay Recapture Tax?

If you're a real estate investor planning to sell an income property owned for more than one year then you're probably aware that you will pay a capital gains tax.

What you might not be aware of, however, is the depreciation recapture tax you will also have to pay, and hence may be in for an unpleasant disappointment.

This was suggested to me recently by a real estate investor who did sell his rental property and never saw the recapture tax coming. That is not a good thing. So it seems appropriate to mention it.

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). Capital gains and the recapture tax only apply to a property held for more than one year.

In real life, here's how it works.

When you sell an income property and have a recognized gain, the feds want to tax you for the capital gain, plus they want to tax you for the accumulated depreciation you've taken during the years you owned the property. Because the current capital gains tax rate is 15% and the recapture tax rate is 25%, you wind up paying more tax (thus, get to keep less) at the sale of your property than you would have by having to pay just the capital gains tax alone.

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 at the time you sold your investment property.

You would probably assume that your full gain would be taxed as capital gains. That is, that the full $300,000 gain would be taxed at 15% and thereby you would owe the IRS $45,000.

Imagine the shock when you discover that you owe $55,000. This means a whopping $10,000 more tax than expected, and $10,000 less proceeds than expected.(Say goodbye to the wide-screen television).

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

About the Author

James R Kobzeff is a licensed real estate broker and the developer of ProAPOD Real Estate Investment Software. The software solution that puts rental property cash flow and rate of return analysis at your fingertips.

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posted by Real Estate @ 8:47 AM