Passive Investor Series Part 12: Depreciation Recapture
This post originally appeared as the writer's LinkedIn "Passive Investor Pet Peeves" series. It has been re-posted and edited here with permission.
Much is discussed about the amazing advantages of depreciation when investing in real estate. This is 𝗼𝗻𝗲 𝗼𝗳 𝘁𝗵𝗲 𝗯𝗶𝗴𝗴𝗲𝘀𝘁 𝗮𝗱𝘃𝗮𝗻𝘁𝗮𝗴𝗲𝘀 𝗳𝗼𝗿 𝗮 𝗽𝗮𝘀𝘀𝗶𝘃𝗲 𝗶𝗻𝘃𝗲𝘀𝘁𝗼𝗿 𝘁𝗼 𝗶𝗻𝘃𝗲𝘀𝘁 𝗶𝗻 𝗿𝗲𝗮𝗹 𝗲𝘀𝘁𝗮𝘁𝗲 𝘃𝗲𝗿𝘀𝘂𝘀 𝗼𝘁𝗵𝗲𝗿 𝗽𝗮𝘀𝘀𝗶𝘃𝗲 𝗼𝗽𝗽𝗼𝗿𝘁𝘂𝗻𝗶𝘁𝗶𝗲𝘀, such as stocks.
When bonus depreciation is taken in a property, then the depreciation accelerates exponentially. Bonus depreciation is a form of accelerated depreciation used with a cost segregation study. It allows you to take 100% of the accelerated benefit and utilize it all in year one of ownership. It’s an amazing perk, but it doesn’t last forever. In its current form, the full benefit lasts on properties acquired through the end of 2022.
Because depreciation losses accumulated in a syndication or passive investment can only offset passive income, it is common to accumulate a large amount of these losses unless you become an active investor.
One downside of depreciation that is often spoken less about is the concept of 𝐃𝐄𝐏𝐑𝐄𝐂𝐈𝐀𝐓𝐈𝐎𝐍 𝐑𝐄𝐂𝐀𝐏𝐓𝐔𝐑𝐄.
Depreciation recapture is the gain realized by the sale of depreciable capital property that must be reported as ordinary income for tax purposes. In short, 𝐲𝐨𝐮 𝐡𝐚𝐯𝐞 𝐭𝐨 𝐩𝐚𝐲 𝐭𝐚𝐱𝐞𝐬 𝐨𝐧 𝐭𝐡𝐞 𝐝𝐞𝐩𝐫𝐞𝐜𝐢𝐚𝐭𝐢𝐨𝐧.
Whether or not you take depreciation in a real estate investment, depreciation recapture is calculated. Let me repeat it another way, 𝐲𝐨𝐮 𝐡𝐚𝐯𝐞 𝐭𝐨 𝐩𝐚𝐲 𝐭𝐡𝐞 𝐝𝐞𝐩𝐫𝐞𝐜𝐢𝐚𝐭𝐢𝐨𝐧 𝐫𝐞𝐜𝐚𝐩𝐭𝐮𝐫𝐞 𝐭𝐚𝐱𝐞𝐬 𝐫𝐞𝐠𝐚𝐫𝐝𝐥𝐞𝐬𝐬 𝐨𝐟 𝐰𝐡𝐞𝐭𝐡𝐞𝐫 𝐲𝐨𝐮 𝐭𝐚𝐤𝐞 𝐢𝐭. I made this mistake on one of my early properties.
There are several strategies to help offset the depreciation recapture and capital gains from the sale of an investment property. This includes a 1031 exchange and something I call the 𝐁𝐚𝐜𝐤𝐝𝐨𝐨𝐫 𝟏𝟎𝟑𝟏.
𝐓𝐡𝐞 𝐛𝐚𝐜𝐤𝐝𝐨𝐨𝐫 𝟏𝟎𝟑𝟏 𝐬𝐭𝐫𝐚𝐭𝐞𝐠𝐲 𝐢𝐬 𝐧𝐨𝐭 𝐚 𝟏𝟎𝟑𝟏 𝐞𝐱𝐜𝐡𝐚𝐧𝐠𝐞, 𝐛𝐮𝐭 𝐲𝐨𝐮 𝐰𝐢𝐥𝐥 𝐝𝐞𝐟𝐞𝐫 𝐭𝐚𝐱𝐞𝐬 𝐨𝐧 𝐭𝐡𝐞 𝐜𝐚𝐩𝐢𝐭𝐚𝐥 𝐠𝐚𝐢𝐧𝐬 𝐥𝐢𝐤𝐞 𝐚 𝟏𝟎𝟑𝟏 𝐛𝐮𝐭 𝐰𝐢𝐭𝐡𝐨𝐮𝐭 𝐭𝐡𝐞 𝐫𝐞𝐬𝐭𝐫𝐢𝐜𝐭𝐢𝐨𝐧𝐬. There are two caveats to get this done: 1) you are required to invest the proceeds from the sale in one or more real estate syndications or other passive activities, and 2) a cost segregation study at the new investment(s) must be conducted in the same tax year. It will be even more advantageous should the new investment take the bonus depreciation with the cost segregation study in the first year.
Read more about the Backdoor 1031 here.
As a passive investor, ensure the operator is taking depreciation and is conducting a cost segregation study.
As an operator, get a cost segregation study completed and take the bonus depreciation.