What Can Offset Depreciation Recapture? (2024)

Depreciation can be an extremely favorable and advantageous tax benefit for real estate investors.

Depreciation is a tax deduction that allows property owners to lower the costs associated with purchasing and making improvements to income-producing properties. This deduction lowers the amount of taxable income (but not cash flow) generated from rental properties.

There’s a catch, though. Investors must pay back a portion of the depreciation they claimed during the holding period of the asset when they dispose of their income-producing properties. Investors seeking tax-advantaged strategies to offset depreciation recapture have little wiggle room – the IRS assumes you took advantage of allowable depreciation deductions even if you did not.

Below we’ll provide a brief refresher on how depreciation works, and then we’ll lay out some strategies investors can consider that may help offset depreciation recapture.

How Depreciation Works

Investors who’ve owned income-producing real estate for any length of time are likely quite familiar with depreciation. This deduction allows you to reduce the cost of purchasing and improving an asset over time rather than all at once.

In order to depreciate an asset, investors must meet all of these four guidelines:

• You must own the asset
• It has to produce income or be used in business or trade
• It has to have a determinable useful life
• It has to last longer than one year

There are four primary methods used to calculate depreciation, but straight line is the method most often used by rental property owners. It’s a relatively simple formula, and your depreciation deduction is the same each year you hold the asset. Here’s the formula:

Acquisition cost, less land value/useful life of asset.

For residential properties, the useful life is 27.5 years; for commercial properties, it’s 39 years. Acquisition costs can include the purchase price of the property, and any associated costs such as inspections and title recording fees. Your accountant can help you determine which costs are depreciable and which are fully deductible.

Strategies to Offset Depreciation Recapture

As we mentioned in the opening, there’s not much investors can do about depreciation recapture. If you took the deduction and have gains greater than your adjusted cost basis, which is highly likely for many property owners given the high rates of property appreciation seen across the country over the last decade, you’ll pay taxes on the gains that are attributed to your depreciation deductions (as well as capital gains taxes on the rest of the profits). Depreciation recapture is taxed at the taxpayer’s nominal income tax rate up to a maximum of 25 percent.

There are two main ways investors can offset depreciation recapture. The first involves capital losses. When calculating your income taxes, any capital losses will reduce your unrecaptured depreciation gains. You’ll report capital losses on Form 8949, Sales and Disposition of Other Capital Assets, and on your Schedule D. You’ll also have to determine if your losses are long-term or short-term.

The second method investors can use to defer depreciation recapture is to complete a 1031 or like-kind exchange. If you swap one investment property for another and roll the entirety of sales proceeds into the new asset, you can defer both depreciation recapture and capital gains taxes. If you divest the replacement asset, though, you’ll have to pay the accumulated depreciation recapture and capital gains taxes. However, if you bequeath the asset to your heirs as part of your estate, the beneficiaries receive the asset at a stepped-up basis to current fair market value that may effectively erase those accumulated gains.

Putting it all Together

In most situations, especially straight sales wherein capital gains are realized, investors will have to pay back a portion of their accumulated depreciation when they divest investment properties. Deferring depreciation recapture by completing a 1031 exchange or offsetting depreciation recapture with capital losses are complex tax situations that typically require the services of professional accountants or tax attorneys.