Today’s subject is a little bit in the weeds, but it’s something every real estate investor should know and understand. I’ve received several questions from readers about my beach condo experience that I previously wrote about - specifically, how I ended up facing a tax bill despite selling the property at a loss. In that situation, it was tied to a previous 1031 exchange, but even with a regular property purchase, it’s not uncommon to receive a hefty tax bill when selling at a lossdue to the joys of DEPRECIATION RECAPTURE. 😱
This very scenario could likely apply to us soon if we decide to sell one of our cabins in the Smoky Mountains next year. Let’s dive into the numbers, and I’ll illustrate how this works:
Mountain Cabin: Bought in 2022 for $486,000 🏡
2022: Took $153,000 bonus depreciation and $7000 straight-line depreciation
2023: Took $7000 straight-line depreciation
2024: Will take $7000 straight-line depreciation
New cost basis in 2025: $312,000 (original price minus depreciation taken)
Current market value: $465,000 (the Smokies market has been suffering due to oversaturation and the economic downturn)
Loss on the sale: $21,000 ($486k minus$465k)(we’ll ignore selling costs for simplification)
No tax bill, right? Wrong! Taking depreciation has lowered our initial cost basis to $312,000, so we now owe depreciation recapture tax on the $153,000 “gain” above that! ($465k minus $312k)
Here are the depreciation recapture tax rates:
Straight-line depreciation (Section 1250): Ordinary income tax rate up to 25%
Bonus/Accelerated depreciation (Section 1245): Ordinary income tax rate (no cap)
Depending on our tax rate, we could potentially face a 37% tax liability on most of that $153,000 gain!
Depreciation recapture is an essential concept for every real estate investor to understand - even if you’re only investing in passive syndications. It’s crucial to run the numbers when deciding whether to take bonus/accelerated depreciation.
For us, it made sense to take the bonus depreciation deduction while we were in the 37% income bracket (we were both still working W-2 jobs in 2022) and to pay back the depreciation recapture now that we’ve early retired and our tax rate is much lower. But that’s not the case for everyone, so make sure to do your homework on the best tax strategy for your personal situation.
Want help reviewing your portfolio and tax strategy? Check out our new Elevate and Invest comprehensive coaching package!
Enjoyed this post? Subscribe to our free weekly newsletter! 📩
Comments