The Strange World of Depreciation Tax When You Sell

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Most real estate investors follow one simple plan for depreciation of their real estate assets. They parcel out the land value because it’s not deductible. And then depreciate the remainder over 27.5 years if the property is residential or 39 years if the property is not residential.

No strategy. It’s a matter of following the easiest way for depreciation.

But let’s consider whether that makes sense. Unless you plan to hold on to your real estate until you die and then leave it to your heirs, at some point you will sell your property. Most of the time, if the property went up in value, you’ll have taxable gain when you sell. The exception to the tax part of that is if you do a like kind exchange or contribute the property to a charitable trust so that the gain is passed on to charity when you die. For purposes of this blog, we’ll assume that you aren’t doing either of those strategies and the gain is taxable.

First, you need to recapture the past depreciation you have taken. It’s taxed at a flat rate of 25% at the federal level. The accumulated depreciation is deducted from the total gain and the remainder is taxed at your capital gain rate. The highest rate, based on your income is 20%.

So, when you take depreciation you are, in essence, trading 20% or less tax for a flat rate of 25%.

When does that make sense? It makes sense if your marginal tax rate is more than 30%. If you save 30% by taking the depreciation and then later pay 25% to get it back, that difference equals the additional 5% you pay.

When does it not make sense? If the depreciation creates a loss that is suspended, it didn’t save you anything. If your tax rate is lower, it doesn’t make sense.

Depreciation is a strategy. You can accelerate it. You can catch it up. You can skip it. Don’t fall into the trap of just always doing the same thing.

Depreciation is one of the many strategies we discuss during the twice monthly coaching sessions through USTaxAid.

One Comment

  1. Charlie Way says:

    “You can skip it.”

    Is there more discussion somewhere on how to skip it, and the whole “allowed vs allowable” issue? I thought I remembered some discussion about this on here somewhere, but now I can’t find it.

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