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  • Aaron

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 ๐—ผ๐—ป๐—ฒ ๐—ผ๐—ณ ๐˜๐—ต๐—ฒ ๐—ฏ๐—ถ๐—ด๐—ด๐—ฒ๐˜€๐˜ ๐—ฎ๐—ฑ๐˜ƒ๐—ฎ๐—ป๐˜๐—ฎ๐—ด๐—ฒ๐˜€ ๐—ณ๐—ผ๐—ฟ ๐—ฎ ๐—ฝ๐—ฎ๐˜€๐˜€๐—ถ๐˜ƒ๐—ฒ ๐—ถ๐—ป๐˜ƒ๐—ฒ๐˜€๐˜๐—ผ๐—ฟ ๐˜๐—ผ ๐—ถ๐—ป๐˜ƒ๐—ฒ๐˜€๐˜ ๐—ถ๐—ป ๐—ฟ๐—ฒ๐—ฎ๐—น ๐—ฒ๐˜€๐˜๐—ฎ๐˜๐—ฒ ๐˜ƒ๐—ฒ๐—ฟ๐˜€๐˜‚๐˜€ ๐—ผ๐˜๐—ต๐—ฒ๐—ฟ ๐—ฝ๐—ฎ๐˜€๐˜€๐—ถ๐˜ƒ๐—ฒ ๐—ผ๐—ฝ๐—ฝ๐—ผ๐—ฟ๐˜๐˜‚๐—ป๐—ถ๐˜๐—ถ๐—ฒ๐˜€, 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. Itโ€™s an amazing perk, but it doesnโ€™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 ๐ƒ๐„๐๐‘๐„๐‚๐ˆ๐€๐“๐ˆ๐Ž๐ ๐‘๐„๐‚๐€๐๐“๐”๐‘๐„.


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, ๐ฒ๐จ๐ฎ ๐ก๐š๐ฏ๐ž ๐ญ๐จ ๐ฉ๐š๐ฒ ๐ญ๐š๐ฑ๐ž๐ฌ ๐จ๐ง ๐ญ๐ก๐ž ๐๐ž๐ฉ๐ซ๐ž๐œ๐ข๐š๐ญ๐ข๐จ๐ง.


Whether or not you take depreciation in a real estate investment, depreciation recapture is calculated. Let me repeat it another way, ๐ฒ๐จ๐ฎ ๐ก๐š๐ฏ๐ž ๐ญ๐จ ๐ฉ๐š๐ฒ ๐ญ๐ก๐ž ๐๐ž๐ฉ๐ซ๐ž๐œ๐ข๐š๐ญ๐ข๐จ๐ง ๐ซ๐ž๐œ๐š๐ฉ๐ญ๐ฎ๐ซ๐ž ๐ญ๐š๐ฑ๐ž๐ฌ ๐ซ๐ž๐ ๐š๐ซ๐๐ฅ๐ž๐ฌ๐ฌ ๐จ๐Ÿ ๐ฐ๐ก๐ž๐ญ๐ก๐ž๐ซ ๐ฒ๐จ๐ฎ ๐ญ๐š๐ค๐ž ๐ข๐ญ. 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 ๐๐š๐œ๐ค๐๐จ๐จ๐ซ ๐Ÿ๐ŸŽ๐Ÿ‘๐Ÿ.


๐“๐ก๐ž ๐›๐š๐œ๐ค๐๐จ๐จ๐ซ ๐Ÿ๐ŸŽ๐Ÿ‘๐Ÿ ๐ฌ๐ญ๐ซ๐š๐ญ๐ž๐ ๐ฒ ๐ข๐ฌ ๐ง๐จ๐ญ ๐š ๐Ÿ๐ŸŽ๐Ÿ‘๐Ÿ ๐ž๐ฑ๐œ๐ก๐š๐ง๐ ๐ž, ๐›๐ฎ๐ญ ๐ฒ๐จ๐ฎ ๐ฐ๐ข๐ฅ๐ฅ ๐๐ž๐Ÿ๐ž๐ซ ๐ญ๐š๐ฑ๐ž๐ฌ ๐จ๐ง ๐ญ๐ก๐ž ๐œ๐š๐ฉ๐ข๐ญ๐š๐ฅ ๐ ๐š๐ข๐ง๐ฌ ๐ฅ๐ข๐ค๐ž ๐š ๐Ÿ๐ŸŽ๐Ÿ‘๐Ÿ ๐›๐ฎ๐ญ ๐ฐ๐ข๐ญ๐ก๐จ๐ฎ๐ญ ๐ญ๐ก๐ž ๐ซ๐ž๐ฌ๐ญ๐ซ๐ข๐œ๐ญ๐ข๐จ๐ง๐ฌ. 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.

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