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Recapture Tax – What You Pay for Depreciation

James R Kobzeff

If you sell rental property that you've owned for more than one year prepare to pay back the Feds
25% of the depreciation (tax relief) you accumulated during your ownership. It comes from the Tax
Relief Act of 1997 and applies to all IRC Section 1250 gains (which for our purposes means all
rental property investments) and is generally referred to as “recapture” or Internal Revenue Code
(IRC) Section 1250 gain.

Here's the idea. Rather then tax your entire recognized gain at the current 15% rate for long-term
capital gains, the taxman figures that depreciation (cost recovery) has already given you tax relief
during the holding period of the asset and therefore should be taxed at the higher cost recovery
recapture rate of 25%. Consequently, thanks to the recapture tax, you pay more taxes when you
dispose of your income property.

Example: Let's say you sell an apartment complex after several years of ownership and realize a
gain of $300,000 of which $100,000 is attributable to accumulated depreciation. How much tax
will you owe? First, you must pay the recapture tax on $100,000 at 25% ($25,000), and then you
must pay the long-term capital gains tax on the remaining $200,000 at 15% ($30,000). You will
owe the IRS a total of $55,000.

Okay, now do the math without the recapture tax and assume that the entire gain of $300,000 gets
taxed at 15%. In this case, you would owe the IRS $45,000. In other words, because of the
statutory tax rate applied at sale to the cost recovery (depreciation), you owe the IRS $10,000 more
in taxes then if the recapture tax didn't exist.

Here are several other facts about recapture tax in case you're wondering.

1. The recapture of depreciation or cost recovery rules don't apply when the property is
disposed of at a loss.
2. The amount subject to recapture cannot exceed the gain realized.
3. Recapture taxes are paid in addition to and before capital gains taxes and, like capital gains
taxes, can be deferred in a 1031 exchange (which, in fact, is the only way to avoid paying
the recapture tax).

The rate of taxation on the cost recovery (i.e., depreciation) portion of capital gain is currently
25%, but from time to time is subject to change by the legislature. Therefore, always consult a tax
specialist before you sell rental income property and avoid letting the recapture tax blindside you at
tax time.
About The Author

James R. Kobzeff is the developer of ProAPOD® Real Estate Investment Software. Discover how
you can create a rental property cash flow analysis in minutes! Preview our solutions, reports,
screen shots and more at => www.proapod.com

James R. Kobzeff
Phone: 503-949-9034
Email: jamesrk@proapod.com
Web: http://www.proapod.com

©2 0 08 J ames R Ko bz eff . All r ig ht s r eser v ed.