de·pre·ci·a·tion dəˌprēSHēˈāSH(ə) n/noun
a reduction in the value of an asset with the passage of time, due in particular to wear and tear.
|synonyms:||devaluation, devaluing, decrease in value, lowering in value, reduction in value, cheapening, markdown, reduction|
In the world of investment real estate, the government gives us a tax break in the form of “depreciation”. Essentially, depreciation is the wear and tear that your property accumulates and good old Uncle Sam allows us to claim that depreciation of investment property against our income taxes.
That’s the Good News. And like most Good News offered by the IRS there is a flip side that’s not so nice. It’s called Depreciation Recapture.
Let’s look at an overly simple example. Let’s say you purchased an investment property nine years ago for $1 million. You sell it today for $1,500,000. In a perfect world you’d think that your gain was $500,000. ($1,500,000 selling price minus $1,000,000 purchase price should equal $500,000 gain). And since you held the property longer than a year, you’d enjoy favorable long term capital gains treatment at a tax rate of 15%. You’d think the calculation would be 15% of $500,000 or $75,0000.
Remember that little thing called “depreciation” that you were taking each and every year against the property to reduce your income taxes. What you were saving in taxes each year from depreciating the asset now comes back to you when you sell the property. All of the depreciation that you enjoyed must now be added back onto your capital gain. What? Let’s be overly simple and say that on your $1 million property you were taking $33,000 per year in depreciation. Over the nine years you owned it that would equate to $300,000 of depreciation. And, this $300,000 is added to your taxable gain!
You would assume that you’d owe an extra 15% of the $300,000 or an additional $45,000 in taxes. And you’d be Wrong!
When Uncle “recaptures” your depreciation benefit, he ups the ante to 25%! That’s right, Long Term Capital Gains Tax at 15% and Depreciation Recapture Tax at 25%. When the depreciation comes back to bite you on the sale of your property your total taxes upon sale double!
That’s why it’s not uncommon for investment property owners to be faced with combined Federal, State, Local, and depreciation Recapture taxes of 25%, 35% even 45+%!
And that my friends is why Section 1031 makes so very much sense.