Section 1250 recapture

[lendaddy]

Man, I'm learning all kinds of cool new phrases lately! This particular one is quite costly

[kach22i]

Real Estate Investors Beware:
The Capital Gains Recapture Tax Trap
http://www.landlordsoftware.com/recapture-tax.htm

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.

In 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.



About the Author:

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 decisions.

[lendaddy]

I told you it was neat stuff

[sammyg2]

A good tax lawyer (did I say that?) will get around this.
The structure is what is depreciated, but that land is not. The land is what increases in value (unless you made improvements to the structure) so you can offset the appreciation by saying that isn't what you depreciated.
Sounds a bit like picking nits but I've been through this. When I sold a townhouse that was a rental unit I kep the full depreciation credit even though the sale price was substantially higher than the purchase price.
That was about 8 years ago tho, the rules might have changed since then. YMMV

[lendaddy]

Originally posted by sammyg2
A good tax lawyer (did I say that?) will get around this.
The structure is what is depreciated, but that land is not. The land is what increases in value (unless you made improvements to the structure) so you can offset the appreciation by saying that isn't what you depreciated.
Sounds a bit like picking nits but I've been through this. When I sold a townhouse that was a rental unit I kep the full depreciation credit even though the sale price was substantially higher than the purchase price.
That was about 8 years ago tho, the rules might have changed since then. YMMV

Interesting, I'll ask my guys about that.

[kach22i]

Hey, your land may be worth less too if they found hydraulic fluid puddled on the surface.

[turbo6bar]

If you reduce the value of the improvements and subsequently, the depreciation taken each year, then you certainly do reduce the Section 1250 gain, but you also give up the depreciation deduction in yesterday's dollars. In some cases, it's better to take high deduction in say 1980 dollars and pay 25% recapture in 2006 dollars.

ld, I think your depreciation basis cannot be adjusted retroactively. If you took $500k in past depreciation, that's what your upcoming tax return will state, and what your upcoming tax bill will be based upon.

1031 sounding better, eh?

[lendaddy]

1031 can't happen, we have to throw everything back at the company to stay in business. One last hurrah if you will.