If you’ve been investing in real estate already or have at least read much on the subject, you’ve probably either heard about or experienced the benefits of **depreciation**. Rightfully so, the tax efficiency related to depreciating real property gets a lot of attention when talking about the many benefits of investing in real estate. By deducting the depreciation “expense” allowed for the particular type of property you are invested in, you frequently end up showing a net loss on paper despite having had cash flow from the investment throughout the year. This is the passive “paper” loss you might hear discussed – a loss only on paper.

Not only are you *ALLOWED* to take this depreciation expense, you are in fact nearly obligated to take it. By obligated I mean the IRS will keep track of things according to what you are ALLOWED to take, whether or not you took it at all, so it is definitely in your interest to utilize that benefit. The reason this matters is because if at some point in the future you sell a rental property, the total accumulated depreciation taken over the holding period of that asset will be deducted from the original cost basis of the property, thereby contributing to the recognized gain upon a sale. That portion of the gain attributable to the depreciation amount you took (or were entitled to take) will be subject to depreciation recapture tax. This part of the gain is technically termed **“unrecaptured Section 1250 gain”** and is taxed at 25% (for real property). The remainder of the gain will be subject to applicable capital gains tax rates (ordinary income tax rates for short term capital gains and 15-20% for long term capital gains).

An simplified example of the above with real numbers is as follows:

Say you bought a property for $250,000 and have an accumulated depreciation amount taken of $30,000 over 5 years. Your adjusted cost basis would then become $250,000 minus $30,000 = $220,000. Then say you sold that property for $300,000. Your gain would be the difference between the sale price and your adjusted cost basis, so $80,000. The part of the gain attributable to depreciation, $30,000, would be subject to depreciation recapture tax of 25% amounting to $7,500. The remainder of the gain ($50,000) would be considered long-term capital gains which would be taxed at a rate of 15% or 20% depending on what bracket other factors of your individual income and tax situation put you into.

At least one caveat to the above scenario would be in the case where you were utilizing cost segregation to depreciate some components of your rental property on a schedule faster than the normal 27.5 year depreciation schedule for residential property. Cost segregation can be a great way to maximize the amount of depreciation you can expense in the early years of owning a property, but just be aware that the items that you segregate out to depreciate on a faster schedule will be subject to a tax rate on the depreciation recapture of those items at your ordinary income level instead of 25%. That may or may not impact your tax liability as outlined above, but for individuals in the highest tax brackets it could mean a higher tax rate on the gain of the cost segregated items.

It’s always important to make sure you are not completely letting the tax implications be the only reason for doing things one way or the other, but for sure it is good to have taxes in mind as you plan your strategy and make decisions related to your real estate investing. Hopefully this has given you a simplistic evaluation of what depreciation recapture is and how you can determine its impact on your investing strategy in the case of a sale.

Tax-related question: If cash flow comes out to, say 6-7%, I can understand how overall taxes are reduced through the use of depreciation and accelerated depreciation/cost segregation. But I often read that there generally is NO taxes often in the first 5-7 years due to these depreciation factors. If depreciation comes out to 3.6% (1/27.5) of the multi-family apartments, which is, say, 3% after subtracting out the non-depreciable land, even w/ accelerated depreciation, how does this overcome a full 7% of income the first 5-7 years??

Hi Jeff – Good question. You need to consider what that 6-7% and 3.6% is being multiplied by in order to come up with the numbers to subtract from one another to see what is taxable income. You said cash flow of 6-7% but what I believe you are referring to is 6-7% cash on cash return. In that case, say 6% of whatever cash you put down on the property (CoC return). For an example, let’s say you bought a $200,000 property with 25% down ($50,000) of which $125,000 is depreciable. Say your cash flow ends up being $3,000 for the year which is 6% CoC. Note you are multiplying that percentage by your amount of cash in the deal. Your depreciation amount would be $125,000/27.5 = $4,545. From there you can see how you come up with a loss when you subtract $4,545 from $3,000. You aren’t multiplying the percentages you referenced by the same amount, so that is what makes the difference. However, it is worth pointing out that this effect will be less as you decrease the leverage on the property (i.e. increase your cash flow) as at some point your cash flow might exceed your depreciation expense at which point you would then have taxable income.

Hopefully that helped!? If not, happy to illustrate further.