Depreciation is the ongoing reduction in the value of a capital or long-term asset. One of the best examples would be rental property. When the investment property is sold, the depreciation will not necessarily offset capital gains tax, due to something called depreciation recapture. However, depreciation of a capital asset like a home business computer could offset your liability for capital gains tax on the sale of stock, for instance, in the same tax year.
Real Property Depreciation
If you own an investment property and rent it out, chances are you take a yearly depreciation deduction for the property on your income tax return. Currently, the IRS allows your residential rental property to be depreciated over a period of 27.5 years. You can offset or reduce your taxable income each year by dividing the cost basis of the property (not including the land) by 27.5 years. The cost basis of the home is generally the amount you paid for it, plus most of your closing costs and any capital (long-term) improvements made to the property. For example, if you paid $250,000 for the property and made improvements on the home to the tune of $25,000, the annual depreciation deduction would be $10,000 ($275,000 / 27.5). Depreciation lowers the cost basis of the property over the years.
Capital Gains Tax
Capital gains tax is the IRS’s share of any profit you make off the sale of capital assets, such as stocks, bonds or your investment property. Capital gains are taxed at a maximum rate of 20 percent. As of 2010, for those individuals in the 28 percent tax bracket, capital gains are taxed at a maximum of 15 percent. For those in the 15 percent or lower tax bracket, the rate is zero percent. Assets held less than 12 months are taxed as ordinary income at your regular income tax rate. Capital gains tax is only assessed on long-term assets, such as real property.
Depreciation Recapture Tax
Claiming depreciation on your rental property is not optional. You must either claim the maximum amount allowed or the allowable amount. Depreciation recapture is essentially a specially-taxed type of capital gain, realized when you sell your investment property. It is pointless to try and avoid depreciation recapture tax by not taking depreciation deductions for your property, as the unclaimed depreciation will still be subject to recapture upon selling. Depreciation recapture means you must take the sum of all previous depreciation deductions on the property and count it as income. The resulting amount is taxed at a maximum rate of 25 percent. In IRS language, this is known as an unrecaptured Section 1250 gain.
Passive Activity Losses
If you sell your investment property for a gain, the depreciation will not offset capital gains tax. The capital gains tax rate is lower than the depreciation recapture tax rate. As depreciation reduces the adjusted cost basis for your property, it is likely the gain on the sale of the property will be higher. However, your liability for depreciation recapture tax can be offset by passive activity losses, which become fully deductible upon sale of the rental property. Rental income is considered to be passive income, and when a renter fails to pay the rent, it can be considered a passive income loss.
- The Free Dictionary: Depreciation, Passive Activity Loss & Depreciation Recapture
- Realty Times: Housing Counsel: Capital Gains Tax and Depreciation
- IRS: Ten Important Facts About Capital Gains and Losses
- Bank Rate: Figuring Depreciation Recapture
- Internal Revenue Service (IRS). "Publication 527 (2018) Residential Rental Property: Depreciation of Rental Property." Accessed Jan. 10, 2020.
- Internal Revenue Service (IRS). "Frequently Asked Questions: Property (Basis, Sale of Home, etc.)." Accessed Jan. 10, 2020.
- Internal Revenue Service (IRS). "Frequently Asked Questions: Sales, Trade, Exchanges." Accessed Jan. 10, 2020.
- Cornell Law School Legal Information Institute. "26 U.S. Code § 1250.Gain From Dispositions of Certain Depreciable Realty." Accessed Jan. 10, 2020.
Based in California, Debbie Donner is a freelance online writer who primarily writes articles related to personal finance. Donner received a Mensa scholarship in 2006 while attending California State University, Fresno. She holds a Bachelor of Arts degree in liberal arts and a multiple-subject teaching credential.