In this edition of the Real Estate Revolution, we will provide our readers with an understanding of depreciation.
Wow! The recently passed tax law just lowered the capital gain tax rate to 15%... great, uh? Well yes, but not so fast! We all know how important it is to understand how the tax law affects our real estate investments. Understanding and forecasting the tax ramifications of rental property ownership is a critical step in the screening and decision making process. Misunderstanding and misapplying the tax law during your analysis can result in ghastly surprises.
As a real estate investor, you can depreciate our rental property and enjoy the positive cash flow resulting from write-off of tax depreciation. Tax depreciation helps shelter rental income that is subject to "ordinary income" rates which is generally higher than capital gain rates. The depreciation taken reduces our property's tax basis, which effectively increases our tax gain when we later sell. If the property is later sold at a gain, this gain may have resulted from the depreciation previously taken. To the extent the gain is attributable to depreciation taken, this gain is generally referred to as "recapture", or Internal Revenue Code (IRC) Section 1250 gain.
The Taxpayer Relief Act of 1997 imposed a 25% capital gains tax rate for unreceptive IRC Section 1250 gains. When coupled with the changes made by the 2003 Tax Act, all depreciation taken can give rise to a higher rate of tax than the newly reduced 15% long-term gain rate. The effect of which is that you will most likely pay more tax upon the sale of a rental property than the 15%.
By way of example, let's assume you purchase a rental property today for $100,000. The total tax depreciation you plan to take over your estimated ownership period is $25,000. You also project the property will be worth $140,000 when it is time to exit your investment. Your projected tax gain will be $65,000 ($140,000 less $75,000 ($100,000 cost less $25,000 depreciation)). Since your gain is greater than your accumulated tax depreciation, the recapture rule will apply. As a result, your tax on sale is not $9,750 ($65,000 x 15%), but rather $12,250, 25.6% more in taxes than what you planned!
The amount subject to the higher (25% or ordinary) rates is limited to the gain on the Sec. 1250 property. If the gain is allocable primarily to the land, the rate of tax on the overall gain from sale may be brought back toward the lower 15% long-term rate. The consequences could range from no benefit for buildings, which have increased in value above their original acquisition basis, to significant benefit where a building is close to the point of being demolished, the principal value component being the land.
In summary, make sure you take into consideration the potential depreciation recapture tax bite when performing your cash flow and rate-of-return analysis.
EDITOR'S NOTE: Adding insult to injury, ALL transaction wherein the investor have depreciated their property, the taxman will expect to receive Self Employment taxes of 15.3% on the first $97,500 of income received by the investor. Depreciation is truly a tax trap for the unwary.
