The Mark Perlberg CPA Podcast
The Mark Perlberg CPA Podcast
EP 107 - Depreciation Recapture - How the IRS Takes Back Your Deduction
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Depreciation recapture can create substantial tax liabilities when selling business assets or real estate, even when selling at or below your original purchase price. We explain how this overlooked tax works and provide strategies to completely eliminate or reduce the tax impact.
• Different types of property face different recapture tax rates – building structures (Section 1250) capped at 25%, personal property (Section 1245) at your ordinary income rate
• Cost segregation studies create larger future recapture tax liabilities that can surprise unprepared sellers
• Installment sales require immediate payment of all recapture taxes even when cash is received over time
• 1031 exchanges can defer recapture taxes when properly structured with equivalent replacement assets
• Creating losses from other properties through cost segregation studies can offset recapture taxes
• Suspended passive losses from prior years can be used to offset recapture income
• Strategic timing of other business expenses can help minimize the tax burden
• Inherited property receives a stepped-up basis, eliminating depreciation recapture concerns
If you want help mitigating taxes from depreciation recapture events and creating lifelong tax savings, visit ProsperalCPA.com/apply
Ready to slash your tax bill? Schedule your free consultation and let's strategize your tax savings together! Book now at: https://www.prosperlcpa.com/apply Or, if you still need more time, here are some other ways to begin winning the tax game...
Take our free Tax Planning Checklist & learn about what tax savings may be available for you in our minicourse at https://taxplanningchecklist.com
At the very least, get on our newsletter to gain access to free live events and exclusive insight you won't find anywhere else: https://www.prosperlcpa.com/subscribe
Depreciation recapture is an extremely important and often overlooked concept when it comes to planning for capital gains events or the sale of really any asset, including real estate in particular, but also the sale of any business asset or business itself. So in the next couple of minutes I'm going to walk you through what you need to know as an entrepreneur about depreciation recapture. Also, I'm going to walk you through how it is taxed, what's the potential damage of the depreciation recapture and what you can do to completely eliminate that depreciation recapture on the sale of any asset, in particular when it comes to real estate. So let's talk about what is depreciation recapture. So depreciation recapture is the reclaiming or the recapture of a depreciation deduction. It's the undoing of that depreciation amount. It's a little tricky for me to explain this in technical jargon, so I think the easiest way is to explain the logic here.
Speaker 1:When you write something off, you're saying you've used it up, it no longer has value and it's an expense. For instance, I spend $100 on my utility bill. That $100 is no longer coming back. I've used up the electricity and therefore I have a tax write-off. Now let's say I buy a truck, buy a truck for $100,000 and let's say I were able to write it all off. Well, when I write it all off, I'm saying this truck is no longer of any value at all and is worth $0. And I fully utilize this truck and spent all the money. So on my balance sheet it has a $0 tax basis. And let's say, fast forward a couple of years, I sell the truck for $30,000. Because I've written off the whole truck, I now have to recapture $30,000 of depreciation. Essentially, what the IRS is saying here is hey, you said that this truck isn't worth anything, but now you're actually selling it for $30,000. You have to recapture that write-off. Even though you're selling it for less than the purchase price, there's still a taxable event here. So depreciation recapture has some unique traits to it. When we talk about what's the impact and how it's taxed and this is extremely important for those of you investing into real estate, but also all of you entrepreneurs should find this important when you sell real estate, you're going to see different types of depreciation recapture.
Speaker 1:So when we write off our real estate, we have something that's called section 1250 property. That's going to be the land. That's not sorry. That that's going to be the land. That's not sorry. That's not going to be the land, because the land doesn't appreciate that is going to be the building itself, the structure. Okay, so let's say we have a building and it's a. Let's say it's a commercial building, it's a hotel. You write it off over 39 years.
Speaker 1:Whatever you've depreciated, that amount has to be recaptured on the sale and that is going to be taxed at your marginal rate but capped at 25%. So let's say you're in the 10% federal marginal rate and you have a building that you bought for a million. You depreciated it for $100,000. You sold it at cost. You have $100,000 of recapture and because you're at the 10% tax bracket, you're going to pay the recapture tax of 10%. But let's say, same example, but you're at the 37% tax bracket, you're capped at that 25%. So the recapture in that example you'd be paying taxes at 25% on that $100,000 of recapture.
Speaker 1:Some other things to consider here is there are other types of depreciation recapture for your real estate, in particular if you have done a cost segregation study or if you've done improvements. Because when you do a cost segregation study you're identifying certain elements of this building that are not really part of the structure itself. So when you do a cost seg you're looking at the furniture, you're identifying a value of things like the refrigerator, even the pavement in the driveways and parking lots, ceiling fans, et cetera, et cetera. These are all things that the IRS says hey, you know what? This isn't going to depreciate, or it's not going to really have the same life depreciation life as the rest of the building. That refrigerator is not going to last as long You're going to write it off in five years. It's personal property, it's a separate type of asset. Long you're going to write it off in five years. It's personal property, it's a separate type of asset.
Speaker 1:So now we have what we call section 1245 property and if we're not talking about real estate, you're most likely going to be referring to section 1245, personal property, for the assets that you were worrying about depreciation, recapture, tax on, anyway. So we have a section 1245 recapture on all these items we found in the cost seg. Or let's say we've done some improvements, so let's say we've replaced the refrigerator. Or let's say we have what we call qualified improvement properties and improvements to the interiors. Certain elements like this that are still seen as not part of the overall structure is going to be that 1245 property, anyways. So when we have all these items. The recapture on that is taxed at your ordinary rate, with no cap at all.
Speaker 1:And this is extremely important for those of you guys who are planning and don't really realize how much you can wind up paying in taxes here when you sell these depreciated assets. So we see a lot of times folks get seduced by the short-term rental loophole or maybe they're just you know. They get started and they realize that real estate investing isn't for them. But this is after they've done taking advantage of the short-term rental loophole. They've done the cost egg, they've driven down their taxes and written off a good chunk of the house. Then you fast forward a few years later and you realize, hey, this is taking up way too much time. It's not even profitable. I don't have time for my kids. I still got to work a full-time job. Let's get rid of this stinking property. I just want to have something that's more passive. Let's get rid of this stinking property. I just want to have something that's more passive.
Speaker 1:And then you find out that you're going to, let's say, you bought it for a million and you're selling it for a million. Two See at $200,000 of cap gains. That's not so bad, but wait a second. We have this recapture. Let's say we wrote off $300,000, and that would be realistic figures from a cost seg. Let's say we wrote off $300,000, and that would be realistic figures from a cost seg. Let's say we wrote off $300,000 for bonus depreciation on the cost seg. Well, all of a sudden we have $300,000 taxed at our marginal rate. So some tax planning has to be done here, or you're going to wind up paying back some or even more of the tax savings that you've created from this cost seg when you bought the property, of the tax savings that you've created from this cost seg when you bought the property.
Speaker 1:So what I want you to think about here is when these events are coming, what can we do to mitigate the taxes? Now on the recapture and we're not just thinking about the recapture here, though, we want to be thinking about everything here, right? So it's not just the recapture, the depreciation there's a good chance. Unless you're selling something at how much you purchased or less, especially with real estate, where you likely sell your assets at more than the cost, we're likely to have long-term or short-term cap gains on these assets as well. So some of the planning strategies I'm going to discuss here relate to depreciation recapture, but it also factors in how we can mitigate the capital gains tax.
Speaker 1:Also, there are other tax traps that we got to watch out for too. We have our net investment income tax at 3.8%. If you don't have real estate professional tax status or take advantage of the STR loophole, we also have to, and it's a real estate investment. We also have to factor in state taxes on top of these federal taxes that we're talking about here. So one of the things I want you to think about that is obviously something that you have heard of before for capital gains planning with real estate is the 1031 exchange. Obviously, we've done this many times and you can avoid the recapture with a 1031 exchange. However, we need to find that the replacement property has equal or greater amount of that $1,245 property to completely mitigate the recapture of that. Remember, if we've done a cost seg, we're pulling items out of that building and saying this is personal property. So when we find the replacement real estate, we need to say that that new piece of real estate has personal property of the equivalent value of what we're selling, just like any other 1031,. There are other variables, but I'm going to keep this simple for the audience that the replacement property has to be of equal or greater value here.
Speaker 1:Some other things to think about here and here's a tax trap is installment sales. When you do an installment sale, you're selling something to the buyer over time. So instead of recognizing the capital gain at once when I sell my property let's say I sell this to a buyer over 10 years I don't recognize a capital gain immediately. I recognize the gain spread out over 10 years. However, when it comes to depreciation recapture because it's treated kind of as ordinary income on that 1245 property, that personal property, that big chunk of property that we wrote off for bonus depreciation on our cost segs we actually pay 100% of the depreciation recapture tax immediately in an installment sale. So if you're selling a business with assets that have bonus depreciation or you're selling your real estate this is where I see it most common appreciation or you're selling your real estate this is where I see it most common.
Speaker 1:A lot of folks think the installment sale will spread your capital gains and all these taxable amounts into lower brackets over time. But this can be really problematic because you're not getting all the cash up front and now you have this big tax bill because you're recognizing all this recapture immediately and what you're going to find is you may not have enough liquidity because the sale is taking over time. You may not have enough cash and liquidity to put it into other areas that will mitigate this depreciation recapture tax. So this can be very challenging.
Speaker 1:Now, the installment sale is one of many strategies for capital gains planning, but if we're going to mitigate our cap gains with an installment sale, we will want to make sure we have enough liquidity or at least some sort of plan to mitigate the recapture on this transaction. Qualified Opportunity Zone funds are another capital gains planning tool that will not eliminate your recapture tax. So if you're going to do a qualified opportunity zone, which we love, you may need to stack this with another strategy. However, we also may be able to find, under certain circumstances, that the qualified opportunity zone fund creates other write-offs to offset the capital gain event and the recapture. Charitable remainder, trust and other charitable strategies are valid ways of mitigating the recapture. If you were to gift it to a trust or put it into a trust, it gives you a charitable tax deduction. Not only does it mitigate the cap gains, it will mitigate the recapture. It will mitigate the recapture.
Speaker 1:Now here's one idea that I think is going to be most practical to our audience is just to create losses from other places to offset the capital gain and depreciation recapture event. So when you have a real estate portfolio in particular let's talk about real estate first when we have a capital gain event, we can use losses from other properties to offset the taxable amount of that capital gain event and the recapture. So let's say I have a capital gain and depreciation recapture amount from the sale of one multifamily property and I have six other multifamily rentals. There's a few things here that might come to play here to mitigate or completely eliminate the taxes on the transaction. One I may have suspended losses. You can find this on form 8582 of the tax return. You're going to see unused losses from prior year returns. If they were unused because maybe you didn't have any income for it to offset, or let's say you didn't have real estate professional tax status and these were passive suspended losses, they're eventually going to carry forward and offset not only potential capital gains but recapture events. Also, if you have losses in that year from other rental properties, they're going to. Even without real estate professional tax status or SCR loopholes, they're still going to be used to offset the cap gain and recapture on that event. One potential strategy here is to create losses from your other rentals to mitigate the taxation on this event. So we could do a cost segregation study on the property not being sold and those losses will be considered in the calculation of your net real estate rental income. And if you do a cost seg on another property in your portfolio, those losses will net against the gain and recapture on the sale of whatever is creating that recapture or gain.
Speaker 1:Now some other things to consider here. A lot of times we have these capital gain events and clients are very concerned about what that means. Well, a lot of times this kind of fixes itself to a good amount here, because the reason why they're selling this property is they want the cash to do other things. And a lot of times they want the cash to buy more assets or buy more real estate or pay for other expenditures. So if you're redeploying the cash on these transactions into other things that create write-offs, you may find that those business losses will offset the potential gains and recapture from the sale of any assets. So and you may find this in particularly true with real estate, because when you sell real estate or really not just real estate, but other assets as well here you have a down payment that you're going to get back.
Speaker 1:So think about this. Let's say I have I put $500,000 into a piece of real estate and then I paid off $100,000 in the mortgage. I have $600,000 of equity and I sell it for a million dollars, so $400,000 of the transaction may go to pay off the loan. But now I have $600,000 of cash. You pay off the mortgage and then, let's say, you use the remaining amount of funds to whatever, whatever you want to do, to create additional write-offs, because the cash that hits your account in this transaction especially if we hold real estate for a long time if the cash that hits your account is greater than the gain because you're getting your principal back, you may find that you have enough liquidity to just create business losses and offset other income. If you're using leverage on the transaction whether it's using leverage to buy a vehicle or other real estate that may be the instance as well.
Speaker 1:Here's where the challenge comes in. If you're a real estate investor and you have this transaction that creates depreciation, recapture and capital gains, and let's say we want to use our funds to pay off our debts. Now we might find ourselves in trouble, because paying off debts doesn't create any write-offs. It's simply a reduction in accounts payable. You don't get any other new tax deductions when you pay down the loan on your other mortgages or your personal home whatever. So here's an instance where we're reducing our liquidity and we're not getting write-offs. So here we want to think about how can we be resourceful and create other tax reductions, and there's a whole world of tax planning opportunities and considerations here that we can consider.
Speaker 1:Some other things that you may want to consider here is holding the property until you die, right. So because when you die, your heirs inherit the property and then it gets stepped up to fair market value. There is no future recapture when you inherit the property. So let's say I bought a property for a million dollars, I fully wrote it off as a $0 basis, and then I die, my heirs inherit it, and when they inherit it let's say the fair market value is $2 million there's no recapture, they just inherit the property and the depreciation starts all over again at $2 million. I've seen a few people recommend that they gift it to their parents. So then what happens is when you gift a depreciated asset, the basis stays the same. So let's say we've written off the property, then we give it to our parents. Well, eventually you inherit the property and it gets set up to fair market value and the depreciation starts again. And it gets stepped up to fair market value and the depreciation starts again. But I'm not likely to recommend that strategy because of all the challenges and logistics of gifting property. But I've seen people do it and I just thought it was a really interesting concept that I thought I'd share with you.
Speaker 1:Some of the things that we want to think about here is just being proactive. You can time other expenses, you can prepay other expenses, you can use leverage to maximize expenses, and then there's a whole world of just general tax strategies and tax deductions and ways to get tax credits to offset the taxes or potential taxes on this transaction. Overall, here, if you want to make sure you're mitigating taxes, make sure you're working with a qualified tax advisor who really understands the tax treatment of all these moving pieces, including depreciation recapture, especially as it applies to your rental property. So some of the things I want you to think about here is when you are selling a property of any kind, in particular real estate. Make sure the recapture is considered here. You can look at your depreciation schedules to determine that amount if it's on a 1040 return 10 on a 1040 return. You also want to make sure that your 8582 is current, so suspended losses are carrying forward to potentially offset the gain event.
Speaker 1:This is in particular important for those of you investing passively who don't have real estate professional tax status. You likely have a lot of unused losses. Make sure you're doing all the foundational tax strategies because things like hiring your kids in Augusta, writing up your travel, writing up your vehicles those all can help in mitigating the recapture as well. As we discussed earlier, other losses from your rental portfolios will offset the recapture on the sale of your real estate. And then if it's just a business, then we don't have to even worry so much about all these restrictions on our losses. So we create general business losses that can also help us out here.
Speaker 1:Also, make sure we consider the state taxes in the potential projections and taxations on this event. So I know I threw a lot out at you here, but hopefully you understood some key points on what is recapture and how it is calculated, and also the different types of recapture right. So if it's personal property, it is taxed at our marginal rate, with no cap at all. If it is that 1250, the building, the recapture is taxed at your marginal rate, capped at 25%, and then you pay state taxes on top of that. So if you want to learn more or you're worrying or losing sleep about the concept of depreciation recapture, we may be able to help you out. Go to Prosperal prosper with an L cpacom slash apply and maybe we can help you not only mitigate the taxes from the depreciation recapture event but all of your income sources to create lifelong tax savings. Have a great day. Hope to hear from you soon.