Even though it’s a buyer’s market, for personal or business reasons you decide to sell to a buyer who offers to pay $105,000. If your total recognized gain is less than your depreciation expense, the IRS requires you to use your ordinary rate when calculating the tax owed.įor example, let’s say the real estate market is in a normal downward cycle. What happens if your gain is less than the depreciation expense? Total tax owed = $8,726 ordinary income tax + $21,000 capital gain tax = $29,726 total tax.Depreciation expense = $36,360 x 24% ordinary tax rate = $8,726 tax based on income bracket.Instead, you’ll be taxed at your higher ordinary tax rate of 24% for the depreciation deductions you’ve taken of the past 10 years, with the rest of your gain taxed at the lower capital gains tax rate: It would be nice to have your total recognized gain of $176,360 taxed at the lower capital gains tax rate.īut, the IRS isn’t that nice. If your total income is $225,000 per year, your ordinary tax rate is 24% and your long-term capital gains tax rate is 15% (based on the 2020 tax tables for married filing jointly). $240,000 property sales price - $63,640 adjusted cost basis = $176,360 recognized gain.When you sell, the IRS recaptures your depreciation by requiring you to use your adjusted costs basis for calculating your gain on sale instead of your original purchase price: Another investor offers to buy your property for $240,000 – double what you paid for it 10 years ago. Thanks to your great local property manager the rental property has generated consistently strong cash flow from qualified tenants. After 10 years of ownership the property adjusted cost basis is: In addition to lowering your taxable income, depreciation also reduces or adjusts the cost basis of your property. How rental property depreciation recapture works

However, what the IRS gives they also take back when you sell the property by recapturing the depreciation. If your NOI is $6,000 per year your taxable income is reduced to $2,364 thanks to the power of depreciation: You can then use the annual depreciation expense to reduce your taxable net income. $100,000 property value (excluding the lot) / 27.5 years = $3,636 annual depreciation expense.The Internal Revenue Service assumes the property – but not the land - wears out or depreciates over time, and that depreciation expense is used to offset taxable net income.įor example, if you paid $120,000 for a rental property and the value of the lot is $20,000, you have a depreciation expense of about $3,636 per year: One of the biggest benefits of investing in real estate is that the IRS allows you to depreciate the property for each year of ownership, up to 27.5 years for residential rental property. Understanding rental property depreciationīefore we discuss the recapture of depreciation for a rental property, let’s quickly review how and why depreciation occurs in the first place. Recapturing depreciation is the process the IRS uses to collect taxes on the gain you’ve made from your income property and to recover the benefits you received by using the depreciation expense to reduce your taxable income. What is rental property depreciation recapture?ĭepreciation recapture occurs when a rental property is sold. In this article, we’ll discuss how depreciation and rental property depreciation recapture work, and how you can avoid paying tax when you sell an income-producing property. However, when an investment is sold, the depreciation must be recaptured and then taxed. Many business and investment assets such as rental property can be depreciated for tax purposes to reduce taxable income.

Noi calculation depreciation