How Does Depreciation Affect Capital Gains Tax on Rental Properties?
Investing in rental properties is an effective way to generate passive income and build wealth over time. One of the significant tax benefits of owning rental properties is the ability to depreciate the property’s value. However, many investors need to pay more attention to how depreciation affects capital gains tax when they sell their rental property. This blog will guide you through the impact of depreciation on capital gains tax and how you can strategically manage it to minimize your tax liability.
What is Depreciation?
Depreciation is a tax deduction that allows real estate investors to recover the cost of their income-producing property over time. It accounts for the natural wear and tear that the property experiences as it ages. The IRS permits property owners to deduct a portion of the property’s year, reducing their taxable income.
The IRS assigns a useful life of 27.5 years for residential rental properties and 39 years for commercial properties. This period determines how long you can continue to depreciate the property.
Example of Depreciation
Imagine you purchase a residential rental property for $300,000, and the value of the land is $50,000. The building, which can be depreciated, is, therefore, $250,000 ($300,000 – $50,000). By dividing this amount by the IRS-assigned 27.5 years, you get an annual depreciation expense of approximately $9,090.91.
Key Takeaway: Depreciation reduces your taxable rental income yearly, allowing you to save on taxes. However, it also impacts your capital gains tax when you sell the property, which we’ll discuss next.
What are Capital Gains and How Are They Taxed?
The profit is known as a capital gain when you sell a rental property for more than its adjusted cost basis (the original purchase price minus accumulated depreciation). Capital gains are generally taxed lower than ordinary income but still represent a significant tax obligation for property owners.
There are two types of capital gains:
- Short-Term Capital Gains: If you hold the property for less than a year, your profit is taxed as ordinary income.
- Long-Term Capital Gains: If you hold the property for more than a year, you benefit from lower tax rates, typically from 0% to 20%, depending on your income level.
How Does Depreciation Affect Capital Gains Tax?
When it comes time to sell your rental property, the IRS requires you to account for the depreciation deductions you’ve earned over the years. This process is called depreciation recapture. Depreciation recapture can significantly impact your capital gains tax liability by requiring you to pay taxes on the portion of the gain attributed to depreciation.
What is Depreciation Recapture?
Depreciation recapture is a tax on the gain you receive from the sale of a previously depreciated property. It is taxed at a maximum rate of 25%. This tax applies only to the portion of the gain related to the depreciation deductions you have taken, not to the entire gain.
Example of Depreciation Recapture
Let’s conLet’s with our earlier example:
- You purchased the property for $300,000, and the land value was $50,000.
- The depreciable basis was $250,000, and you claimed $9,090.91 in annual depreciation.
- Over 10 years, you have accumulated $90,909 in depreciation.
If you sell the property for $400,000, the IRS will require you to recapture the $90,909 in depreciation, which will be taxed at up to 25%.
Calculation:
- Sale Price: $400,000
- Adjusted Cost Basis: $300,000 (purchase price) – $90,909 (depreciation) = $209,091
- Capital Gain: $400,000 (sale price) – $209,091 (adjusted basis) = $190,909
The depreciation recapture portion ($90,909) is taxed separately from the remaining gain. This highlights how depreciation can increase your taxable income when selling the property.
How to Reduce Capital Gains Tax on Rental Properties
Understanding how depreciation affects capital gains tax is essential, but you also need strategies to reduce your tax liability. Here are some effective methods:
- Utilize a 1031 Exchange
A 1031 exchange allows you to defer paying capital gains and depreciation recapture taxes by reinvesting the proceeds from the sale into a like-kind investment property. This strategy lets you continue building your real estate portfolio without immediately incurring tax liabilities.
Key Tip: To qualify, the new property must be of equal or greater value, and the transaction must strictly follow IRS guidelines.
- Convert the Property to a Primary Residence
If you convert your rental property into your primary residence and live in it for at least two of the last five years before selling, you may qualify for the primary residence exclusion. This exclusion allows you to avoid capital gains tax on up to $250,000 for single filers or $500,000 for married couples.
Caution: This strategy only reduces the capital gains tax. You are still liable for depreciation recapture tax.
- Offset Gains with Losses
If you have other investments that have experienced losses, you can use these to offset the gains from the sale of your rental property. This strategy, known as tax-loss harvesting, can help reduce taxable income.
Important Considerations
Keep Detailed Records
Maintaining accurate records of your property’s price, depreciation deductions, and capital improvements is crucial for calculating the adjusted cost basis and minimizing tax liability.
Consult a Tax Professional
Real estate taxation can be complex, especially when dealing with depreciation and capital gains. It’s advisable to work with a tax professional who can guide you through the process and help implement strategies tailored to your specific situation.
Final Thoughts
Understanding how depreciation affects capital gains tax on rental properties is vital for any real estate investor. While depreciation offers immediate tax savings by reducing your taxable income, it can also increase your tax liability when you sell the property due to depreciation recapture. You can potentially reduce your tax burden by employing strategies like a 1031 exchange or converting the property into a primary residence.
In conclusion, depreciation and capital gains tax are interconnected aspects of real estate investing that require careful planning. Knowing how these factors play together, you can make informed decisions that maximize your investment returns and minimize your tax liabilities.
