|Real Estate Investors Beware:
The Capital Gains Recapture Tax Trap
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 we took. 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 unrecaptured 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.
As an example, if
accumulated depreciation (otherwise subject to "unrecaptured section 1250
gain" treatment) is $10,000, but analysis can reduce the gain attributable
to the building at the date of sale to $6,000, then the federal income tax
to a high bracket taxpayer on the $4,000 reduction is reduced from $2,500
to $1,000. The result is a $1,500 tax savings for simply be able to
allocate more of the gain to land that is not subject to the recapture
rather than the building.
summary, make sure you take into consideration the potential depreciation
recapture tax bite when performing your cash flow and rate-of-return
analysis. When you have tax questions, always consult your tax advisor.
(c) Copyright 2003, All Rights Reserved.
Douglas Rutherford, CPA is the founder and CEO of RentalSoftware.com LLC whose
main product is the Landlord's Cash
Flow Analyzer. The software is designed to help landlords
compute cash flow, profitability and the rate-of-return on their rental property investments.
Income taxes are a critical component of calculating cash flow in making real estate investment
Back to Real Estate Investing Articles