Understanding Depreciation When You Sell A Rental Property [Guide]

When you own rental property, numerous monetary benefits and tax breaks may be yours. 

Renting out a property is a reliable source of cash flow. Maintenance fees, property taxes, and insurance are all deductible expenses from your taxable income. Real estate also appreciates with time, increasing your potential for a profit if you decide to sell. 

Selling a rental property might be a smart financial move for various reasons. Real estate investors who made large down payments some years ago may opt to cash out in a market where buyers are willing to pay practically anything for a home.

There are other reasons owners sell, such as major repairs they would rather not invest in or the fact that a new owner prefers not to be a landlord. If you have a reliable renter in place, you may be able to improve your earnings by offering your property to a landlord or another investor in the rental market.

Several other factors might motivate the decision to sell a rental property. Maybe you’re going through some changes at home (like having kids or becoming older), and you don’t want to cope with collecting rental income and expenses anymore. Perhaps you’ve switched to a profession that requires your whole focus, or you’ve decided to invest in something else, like that bakery you’ve always dreamed of having.

Before you’re up to your elbows in flour, there is another piece to consider: rental property depreciation. Depreciation lowers the property owner’s yearly tax burden for as long as the property is owned. But what happens when you decide to sell your rental property? We will talk about it in detail below. 

What Does “Depreciation” Mean?

The value of a rental property declines over time due to a process known as depreciation. Depreciation variables include use and age. Depreciation may be written off as an expense on your tax return, bringing down the total cost of ownership of a rental property.

One deduction that property owners are happy to use is the annual depreciation cost. It’s an excellent way to reduce one’s existing tax burden, and let’s face it, everyone likes a smaller tax bill.

Depreciation is a noncash item that may be written off yearly on your tax return. To reduce your current tax obligation as a property owner, you may write off the asset’s yearly depreciation.

For tax reasons, the projected useful life of a property is 27.5 years; hence, owners may claim depreciation on a residential investment property for this length of time.

The Internal Revenue Service allows depreciation on rental properties provided they fulfill the following criteria:

  1. You are the rightful owner of the land. Despite any liens on the property, you are still legally the owner;
  2. You put the property to good use, specifically for commercial or rental income-generating purposes;
  3. The asset has a finite lifespan, meaning usage, neglect, or the passage of time will eventually depreciate the rental property;
  4. The asset has a lifespan of more than a year.

Even if the property otherwise qualifies for depreciation, it cannot be written off if it is put in service and stopped being used for business purposes in the same year. In other words, you cannot benefit from depreciation in the year of sale of rental property.

Remember that land isn’t subject to depreciation since it’s never consumed. Landscaping, planting, and clearing are all deemed to be part of the cost of the land, not the structures, and hence cannot be depreciated.

Example Of Depreciation Recapture For Rental Property

You must pay depreciation recapture tax if you recoup more money from the sale of an asset than you first invested in it.

To determine this, multiply your ordinary income tax rate by the amount of depreciation taken advantage of during your ownership of the property.

We’ll pretend that ten years have passed since you bought the house and that you eventually got $500,000 for it and your income tax rate is 18%,

If you’ve claimed $100,000 in depreciation over the course of ten years, and your tax rate is 18%, you’ll owe $18,000 in depreciation recapture tax.

Capital gains are subject to a different tax rate than depreciation recapture tax and may be anywhere from 0% to 20%, depending on an individual’s federal income tax bracket. If you use our example and assume you pay tax at the 15% rate, your capital gains tax will be:

Initial investment: $200,000

Selling price: $500,000

Gain on investment = selling price minus initial investment.

Gain on investment: $500,000 minus $200,000 = $300,000 in taxable capital gain

The capital gains tax is $45,000

Do You Have To Pay Back Depreciation On Rental Property?

While selling a property, many owners fail to account for the depreciation costs they incur. They will instead account for the standard capital gains tax, only to be blindsided by their tax professional’s discovery of extra tax liability. 

Learning about depreciation when selling a rental property would be best. When an owner sells a property for a profit, the IRS takes back some of the tax-deductible depreciation they took advantage of in earlier years – otherwise known as the recapture of depreciation on rental property. Investment profits are also subject to taxation by the Internal Revenue Service. If you own the property for more than a year, any profit you make from selling it will be subject to long-term capital gains tax rates. 

The amount of tax you owe on depreciation recapture depends on your income tax rate and the overall amount of depreciation deductions you took out throughout the property’s useful life. On the other hand, the capital gains tax due on the sale of a home depends on how much money you’ll make from it. 

Property owners benefit greatly from depreciation as a tax deduction. When it comes time to sell the residential rental property, however, the depreciation recapture tax may add up to tens of thousands of dollars in additional costs. For the Internal Revenue Service, this is a means of recuperating the tax benefit you received while you were the property’s owner.

What To Do About Depreciation When You Sell A Rental Property?

There are, thankfully, techniques to dodge hefty depreciation recapture and capital gains taxes. Buying another comparable property and passing it on to heirs will allow you to delay paying taxes on the sale earnings.

The IRS permits property owners to avoid paying depreciation recapture tax and capital gains on the sale of investment real estate through a tax-deferred exchange known as Internal Revenue Service Code Section 1031. A 1031 exchange may be a powerful tool for landlords, but only if they approach it strategically. By putting off paying taxes on their capital gains, property owners may continue to build their wealth by purchasing other assets.

What if you don’t want to make a property transfer but still need to figure out how to avoid depreciation recapture tax? Here’s when your estate plan comes in handy. You may keep the property, deduct depreciation expenses yearly, and leave it to your heirs when you die.

This strategy may help you accumulate wealth over time and shield it from deferred depreciation recapture tax and capital gains tax. If a deferred tax debt or depreciation recapture tax is attached to the rental property, your heirs will not be responsible for paying it. After a property owner passes away, the cost basis in the property is “stepped up” to account for inflation.

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