Real estate

Depreciation recapture, the bill nobody budgets for

You accelerated deductions on a property and they were worth having. Now you are selling, and a portion of what you deducted comes back. Better to know that number before you agree a price than after.

Every year of ownership, depreciation reduced your taxable income. It felt like a gift, and it was certainly useful. What it was not is permanent.

I meet owners at closing who have never heard the word recapture, and by then the price is agreed, the proceeds are allocated and the options have closed. This is an entirely avoidable surprise.

The misconception

The belief is that depreciation deductions were free money that reduced tax permanently. They reduced tax in the year taken. They also reduced your basis in the property by the same amount, and basis is what the gain on sale is measured against.

What is actually happening

Your adjusted basis falls each year by the depreciation you took. Sell for the same price you paid, and you still have a gain, because the basis is lower than the price. That gain has to be separated into parts before the tax on it can be worked out.

Some of it relates to the depreciation you claimed and is taxed under recapture treatment. Some of that is treated as ordinary income and some falls under a separate rate treatment for real property, and the split depends on which components generated the deductions. The rest is capital gain.

Acceleration is a loan against the sale, not a gift. The terms are good, and it is still a loan.

The word to notice is claimed, and it is worse than that. The calculation generally uses depreciation allowed or allowable, which means a basis reduction can apply even for years when nobody actually claimed it. Skipping the deduction does not avoid the reckoning.

This is why a cost segregation study has two sides. Pulling deductions forward into short-life components generally means more of the eventual gain falls into the less favourable treatment on the way out.

The number

The range depends on how long you held, how much depreciation you took, which components produced it, your marginal rate, the rate treatment applying to each portion, your state and the sale price itself. On a property held a long time with heavy acceleration it can be a significant share of the proceeds.

The rates and the treatment of each component are specific and they change, so any figure you use for planning should be run for the year you actually expect to sell in.

What it actually requires

One thing, mainly, and it is often missing:

• A current adjusted basis figure, including every year of depreciation taken or allowable
• The component breakdown if a study was done, so the split can be calculated
• Records of capital improvements, which increase basis and are routinely forgotten
• A projection of the tax before the price is agreed
• The proceeds allocation in the contract, which is negotiable and matters

Improvement records are worth chasing. Owners remember the roof and forget everything else, and each forgotten improvement raises the taxable gain unnecessarily.

Planning around it

This section replaces the usual one, because there is no group this does not apply to. Every owner who depreciated will eventually meet it. What varies is whether you meet it on your terms.

Holding period is the first lever. A longer hold spreads the benefit of the deductions over more years, which improves the trade even though the recapture still arrives.

An exchange into replacement property is the second. Done correctly it defers the whole reckoning rather than settling it, which is a real option for an owner staying in property. It has strict requirements and an unforgiving timetable, covered separately.

Beyond those, the year of sale matters. Recapture stacks on top of your other income, so selling in a year when your other income is unusually high costs more than selling in a quieter one. Instalment structures can spread the capital portion, though recapture treatment does not always cooperate. And the estate rules treat property held until death differently, which is a conversation worth having rather than a plan to make casually.

The timing

Modelled before listing. Once a contract is signed the structure is fixed, the exchange route may already be closed, and the only remaining question is how large the cheque is.

This is a planning question

A preparer calculates recapture after the sale, which is reporting rather than advice. Knowing the number in advance, choosing the year, and deciding whether to defer are decisions made before the property goes on the market.

This is general information, not advice on your own situation. Whether any of it applies to you depends on facts this article does not know.