depreciation recapture - Posted by Rick

Posted by JHyre in Ohio on March 08, 2002 at 11:05:52:

I LOVE depreciation! If I’m in the 40% bracket and “pay back” at 25% recapture rate, it’s like a $40x loan, repaid at $25x WHEN and IF I want to pay it back! Throw 1031’s into the mix and Hoooooweeee! (I learned that last part in Texas).

John Hyre

depreciation recapture - Posted by Rick

Posted by Rick on March 07, 2002 at 22:17:28:

Imagine a fully depreciated property. Sold on an installment basis. Capital gain is spread out over the payments as principal comes in. My question is how depreciation recapture is handled. If depreciation recapture is spread out too, is it pro-rata with the capital gain or is depreciation recapture taken first? And is depreciation of the building handled differently than depreciation of other property (carpets, furniture, etc.). Hope my question makes sense to somebody. Thanks.

Election year - recapture rate reduction. - Posted by David H

Posted by David H on March 08, 2002 at 12:02:49:



Gains, until very recently, were taxed at one rate, regardless of their source. Real estate owners paid a 28% rate on gains attributable to appreciation, known as capital gains, and a 28% rate on gains due to depreciation, known as depreciation recapture.

However, in 1997, Congress made a bold reduction in the capital gains tax rate, cutting it to 20%. To lessen the budgetary cost of the entire tax package, it also sought to leave the depreciation recapture rate at the old rate of 28%. In doing so, Congress sought for the first time to establish a different rate for the two types of gains, and to tax depreciable gains at a higher rate.

Although real estate was unable to obtain the full cut that capital gains enjoy, it achieved a significant victory by reducing the depreciation recapture rate from 28% to 25%. The Congressional Joint Tax Committee valued the savings created by this rate reduction, in just the first five years, at almost 4 billion dollars. However, this still leaves the two types of gains taxed at two different levels.

Recent Activity

Members of the House Ways and Means Committee and the Senate Finance Committee, the congressional bodies that have jurisdiction over taxes, recognize that holders of tangible assets are placed at a disadvantage by having a depreciation recapture rate that differs from the capital gains tax rate. As such, major tax reduction efforts, such as H.R. 2488 - the ?Taxpayer Refund and Relief Act of 1999,? often contain provisions to lower the depreciation recapture rate from 25%. Unfortunately for real estate, the impasse between the president and Congress over tax reduction in general has left the issue unresolved. With a new Congress and new Administration in 2001, BOMA International remains hopeful that it can finally put an end to this tax inequity.

Action Requested

Assets that can be depreciated, like real estate, should receive fair treatment under the US tax code. Your congressmen and senators need to understand that a higher rate for depreciation recapture places tangible assets at a disadvantage to other investment vehicles. Commercial real estate owners and managers are encouraged to write members of the House’s Ways and Means Committee and the Senate’s Finance Committee to reiterate our goal of tax equity for depreciable assets.

Re: depreciation recapture - followup - Posted by rick

Posted by rick on March 08, 2002 at 11:47:57:

Wow, great answers. Thanks Dave T, bob & JHyre.

As a followup, could the same property be sold on an interest only basis to defer all the tax?

I’m not actually selling, but looking to put together proposals to “tired landlords”. Thanks for any input!

Re: depreciation recapture - Amendment - Posted by Dave T

Posted by Dave T on March 08, 2002 at 08:20:57:

John Hyre has sent me a heads up on a rule change that affects my answer. I quote from his e-mail to me:

“…the new rule is that higher tax gets paid first. Using your example, the first $75k of taxable portion of payments is taxed at 25%, the remaining taxable payments are taxed at 20%. Obviously advantageous for the IRS.”

Thanks, John, for keeping us on the right track.

Re: depreciation recapture - Posted by Dave T

Posted by Dave T on March 08, 2002 at 24:19:41:

I am not a tax professional nor do I pretend to be an expert. That said, here is how I would answer your question.

Since you said that the property was fully depreciated, your adjusted basis is now just the original land value. For example, let’s say that you purchased your investment property for 100K – 25K is attributed to the land and 75K to the improvements. Let’s say that you sold the property with 100% financing for 200K using an installment sale.

Since your gross profit on this sale is 175K (200K sale price minus your 25K adjusted basis), 87.5% of the principle payments you receive in any year are taxable income (175K divided by 200K). The rest is a return of your basis and not taxable. Interest received in any year is taxable as ordinary income.

For the taxable portion (87.5%) of the principle payments you receive in any year, allocate the payments between capital gain due to appreciation and gain due to depreciation. Because 75K of your 175K profit is due to depreciation, I would allocate 42.85% (75K divided by 175K) of the taxable principle payments received to depreciation recapture.

In our example, let’s say that you received $2000 in principle payments in the first full year of your installment sale (remember, interest received is taxable as ordinary income). Of this $2000, only $1750 (87.5%) is taxable income.

Now allocate this $1750 between capital gain due to appreciation and depreciation recapture. Using our depreciation to total profit ratio, 42.85% – $750 (in round numbers) – is depreciation recapture. The remaining $1000 is taxable capital gains.

Now, the above discussion assumed that you do NOT have any excess depreciation over straight line. If so, then the excess is taxable in full as ordinary income in the year of sale, but then added to your cost basis before making the rest of the calculations I outlined above.

As to the depreciable components you mentioned, unless your sales agreement specifically itemized the components and assigned a value to each as a portion of the aggregate sales price, I would just let the sale price of each component equal its adjusted basis to simplify the tax reporting.

As I said, I am not an expert, but this is how I would do it.

Re: depreciation recapture - Amendment - Posted by bob

Posted by bob on March 08, 2002 at 10:49:20:

But you must remember, that the depreciation deduction hopefully saved you taxes in at least the 28% tax bracket, so you should be aheadat a minimun of 3%!!!

Good Luck & Good Investing.