comprehension Rental asset Depreciation and Recapture Tax

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comprehension Rental asset Depreciation and Recapture Tax

One of the true benefits of owning rental wage asset is that real estate investors can depreciate the asset and enjoy the inevitable cash flow resulting from writing off the tax depreciation--just one of the tax security benefits linked with real estate investing.

comprehension Rental asset Depreciation and Recapture Tax

Here's how it works.

The tax code assumes that the investment asset buildings (not the land) are wearing out over time and therefore becoming less valuable. As a result, they permit wage asset owners to take a deduction for that presumed decline straight through the depreciation deduction (or cost rescue as it's now called in the tax code), which in turn helps the investor security rental wage that is subject to lowly wage rates.

Let's assume, for example, that you purchase a multifamily asset for 0,000 of which 0,000 is attributable to the buildings (the remaining part is land value). The Irs assumes a life of 27.5 years for residential asset (39 years for non-residential property) and therefore allows real estate investors to take an every year depreciation deduction of about ,544 (0,000 / 27.5) except in the first year and selling year, which is slightly less (,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 non-cash deduction--it is not an operating expense, therefore you can take it without having to write a check for it as you would other costs linked with running the investment property. Moreover, if the depreciation deduction is large adequate to exceed the property's income, investors can use it to offset other investment wage and therein sell out 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 and effectively increases our tax gain when we later sell, if the asset is later sold at a gain, the Irs assumes that our gain in part may have resulted from the depreciation we took and in turn imposes a 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 adviser).

Okay, let's look back on our former example and assume that you sell your multifamily asset at a gain greater than your accumulated tax depreciation (which we'll say is 4,232). Since your gain is greater than your tax depreciation, the recapture rule will apply.  As a result, your tax on sale will consist of the recapture tax of ,508 (4,232 x .25) plus a capital gains tax on the adjusted net capital gain.

The part here that you should always inventory for depreciation recapture tax when performing your real estate diagnosis on inherent investment opportunities. Otherwise, you might be unpleasantly surprised to discover that you owe the Irs more taxes than planned when you sell your rental asset and that will not be good.

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