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Depreciation Recapture

Depreciation is a tax benefit that allows property owners to spread the cost of a property over a period of time. However, when a property is sold, any depreciation that was taken on the property is subject to recapture. This means the depreciation taken as a tax benefit must be paid back to the government through taxes.


Depreciation recapture is a tax provision that requires taxpayers to pay taxes on the portion of the depreciation that was previously taken as a tax deduction when they sell or dispose of an asset. Here are some pros and cons of depreciation recapture:


Pros:

  • Depreciation recapture ensures that taxpayers pay taxes on the portion of the depreciation that was previously taken as a tax deduction.

  • Depreciation recapture helps to level the playing field for taxpayers who have taken advantage of the tax benefits of depreciation by ensuring that they pay taxes on the portion of the depreciation that was previously taken as a tax deduction.

  • Depreciation recapture helps to raise revenue for the government.

Cons:

  • Depreciation recapture can be a significant tax liability for taxpayers who have taken advantage of the tax benefits of depreciation.

  • Depreciation recapture can be a disincentive for taxpayers to invest in property or equipment, as they may be reluctant to take advantage of the tax benefits of depreciation if they know that they will have to pay taxes on the portion of the depreciation that was previously taken as a tax deduction when they sell or dispose of the asset.

  • Depreciation recapture can be complex and confusing to understand, and taxpayers may need to consult with a qualified tax professional to ensure that they are in compliance with the rules and regulations related to depreciation recapture.

It's important to note that there are several ways to avoid or minimize depreciation recapture like 1031 exchange, investing in a Qualified Opportunity Zone (QOZ), installment sale, holding the property for more than a year, or donating a conservation easement on the property to a qualified charitable


Depreciation Recapture on a building that had a Cost Seg Performed


A cost segregation study is a way for property owners to identify the personal property and land improvements that can be depreciated over a shorter period of time than the building itself. This can result in significant tax savings for the property owner.


For example, a commercial building with a cost of $2 million was purchased, and a cost segregation study was performed. The study determined that $300,000 of the cost was attributed to personal property, and $280,000 was attributed to land improvements. These items are eligible for a shorter depreciation period, five and fifteen years, respectively.


If the building is sold after ten years, the owner would be subject to depreciation recapture on the personal property and land improvements. The amount of depreciation recapture would be calculated by taking the remaining depreciation on the personal property and land improvements and multiplying it by the highest marginal tax rate in effect at the time of the sale.


Since the personal property has been depreciated over five years, and the building has been sold after ten years, we can assume that all the depreciation has been claimed. Therefore, the recapture of depreciation for the personal property would be $300,000 *, the highest marginal tax rate.


Since the land improvements have been depreciated over 15 years, and the building has been sold after ten years, we can assume that not all the depreciation has been claimed. Therefore, we need to calculate the remaining depreciation on land improvements. Assuming that the land improvements have been depreciated at 7.5% per year, the remaining depreciation on land improvements would be $280,000 * 7.5% * (15-10) = $52,500. Then the recapture of depreciation for the land improvements would be $52,500 * the highest marginal tax rate.


Don't worry; there are ways to strategize around depreciation recapture!


As a property owner, it's essential to know the potential tax implications of selling a property, including depreciation recapture. However, there are ways to minimize or avoid this tax liability.


Section 1031 Exchange


One way to avoid depreciation recapture is through a Section 1031 exchange. A Section 1031 exchange, also known as a like-kind exchange, allows a property owner to defer paying taxes on the sale of a property by using the proceeds from the sale to purchase a similar property. Here is an example of how it would work using the commercial building example provided earlier:

  • Let's say the commercial building with a cost of $2 million was purchased, and a cost segregation study was performed. The study determined that $300,000 of the cost was attributed to personal property, and $280,000 was attributed to land improvements.

  • After ten years, the owner decides to sell the building for $3 million.

  • Instead of recognizing the $1 million gain from the sale and paying taxes on it, the owner decides to use the proceeds from the sale to purchase a similar property, in this case, another commercial building.

  • To do this, the owner will need to identify a replacement property within 45 days of the sale of the original property and close on the purchase of the replacement property within 180 days of the sale of the original property.

  • The owner must use a Qualified Intermediary (QI) to handle the exchange. The QI will hold the proceeds from selling the original property until they are used to purchase the replacement property.

  • Once the replacement property is purchased, the owner will take ownership of the replacement property, and the exchange is complete.

  • The owner will not have to pay taxes on the $1 million gain from the sale of the original property because it was deferred through the 1031 exchange.

It's important to note that the replacement property must be of "like-kind" with the original property, and specific rules and regulations must be followed to qualify for the exchange. Additionally, the owner must be sure that the replacement property costs at least as much as the sale price of the original property to avoid any tax liability.


Investing in Qualified Opportunity Zones (QOZ):


Another way to avoid depreciation recapture is by investing in a Qualified Opportunity Zone (QOZ). Investing in a QOZ allows the property owner to defer paying taxes on the gain from the sale of the property and potentially eliminate taxes on the gain if the investment is held for at least ten years. Here is an example using the commercial building example provided earlier:

  • Let's say the commercial building with a cost of $2 million was purchased, and a cost segregation study was performed. The study determined that $300,000 of the cost was attributed to personal property, and $280,000 was attributed to land improvements.

  • After ten years, the owner decides to sell the building for $3 million.

  • Instead of recognizing the $1 million gain from the sale and paying taxes on it, the owner decides to invest in a Qualified Opportunity Zone (QOZ)

  • The owner must invest the proceeds from the sale of the property into a Qualified Opportunity Fund (QOF) within 180 days of the sale.

  • The investment in the QOF must be for at least the same amount as the gain from the sale of the property.

  • If the investment is held in the QOF for at least five years, the owner can claim a 10% exclusion of the gain.

  • If the investment is held in the QOF for at least seven years, the owner can claim a 15% exclusion of the gain.

  • If the investment is held in the QOF for at least ten years, the owner can claim a full exclusion of the gain, thus avoiding depreciation recapture.

It's important to note that there are specific rules and regulations that must be followed for the investment to qualify for the exclusion of the gain. Also, the property owner should consult with a qualified tax professional to ensure that the investment is eligible for the exclusion and to determine the best investment strategy.


Installment Sale


An installment sale is a way for a property owner to spread the gain from the sale of a property over a period of time, rather than recognizing it all in the year of the sale. This can help minimize the depreciation recapture's impact on the seller's tax liability.

Holding the property for more than a year before selling means that the gain is considered a long-term capital gain, and the tax rate is lower than the ordinary income tax rate. Here is an example using the commercial building example provided earlier:

  • Let's say the commercial building with a cost of $2 million was purchased, and a cost segregation study was performed. The study determined that $300,000 of the cost was attributed to personal property, and $280,000 was attributed to land improvements.

  • After ten years, the owner decides to sell the building for $3 million.

  • Instead of recognizing the $1 million gain from the sale and paying taxes on it all in the year of the sale, the owner can enter into an installment sale agreement with the buyer.

  • The installment sale agreement allows the owner to receive payments over a period of time, such as five years.

  • As the payments are received, the owner will recognize a portion of the gain each year rather than recognizing it all in the year of the sale.

  • The owner will pay taxes on the portion of the gain recognized each year rather than paying taxes on the entire gain in the year of the sale.

  • If the tax rate is lower in the years, the payments are received than in the year of the sale; the owner may pay less in taxes overall.

It's important to note that, in an installment sale, the seller will receive an interest income on the unpaid balance, and that income is subject to taxation each year. It's important to consult with a qualified tax professional to ensure that an installment sale is the best option and to determine the best payment structure.


Holding The Property For More Than A Year


Holding a property for more than a year before selling it can be a way to avoid depreciation recapture. This is because when the gain from the sale of a property is considered a long-term capital gain, the tax rate is typically lower than the ordinary income tax rate. Here is an example using the commercial building example provided earlier:

  • Let's say the commercial building with a cost of $2 million was purchased, and a cost segregation study was performed. The study determined that $300,000 of the cost was attributed to personal property and $280,000 was attributed to land improvements.

  • After holding the building for more than a year (let's say 15 years), the owner decides to sell the building for $3 million.

  • The owner recognizes a gain of $1 million from the sale.

  • Because the owner held the property for more than a year, the gain is considered a long-term capital gain.

  • The long-term capital gain tax rate is typically lower than the ordinary income tax rate.

  • By holding the property for more than a year before selling it, the owner may be able to pay less in taxes overall.

It's important to note that the tax rate for long-term capital gain may change every year, so it's important to consult with a qualified tax professional to ensure that holding the property for more than a year before selling it is the best option and to determine the best timing to sell the property.


Charitable Contribution


Finally, Donating a conservation easement on a property to a qualified charitable organization can be a way for a property owner to avoid or minimize depreciation recapture when selling a property. This is because the property owner can claim a charitable contribution deduction for a portion of the property's value, which can offset some or all of the gain from the sale of the property.


Here is an example using the commercial building example provided earlier:

  • Let's say the commercial building with a cost of $2 million was purchased, and a cost segregation study was performed. The study determined that $300,000 of the cost was attributed to personal property, and $280,000 was attributed to land improvements.

  • After ten years, the owner decides to sell the building for $3 million.

  • Instead of recognizing the $1 million gain from the sale and paying taxes, the owner decides to donate a conservation easement on the property to a qualified charitable organization.

  • A conservation easement is a legally binding agreement that limits the use of the land in order to protect its conservation values.

  • The owner can claim a charitable contribution deduction for a portion of the property's value by donating the conservation easement.

  • The amount of the charitable contribution deduction will depend on the conservation easement's value and the property's appraised value.

  • The charitable contribution deduction can offset some or all of the gain from the sale of the property and thus can help to minimize or avoid the depreciation recapture.

It's important to note that there are specific rules and regulations that must be followed in order for the conservation easement donation to qualify for the charitable contribution deduction, and it's important to consult with a qualified tax professional to ensure that the donation is eligible for the deduction, and to determine the best strategy.


As a reminder, it's important to note that these are simplified examples, and actual depreciation recapture calculations will depend on each case's specific facts and circumstances. And for that reason, the client should consult a qualified tax professional.


Saba Tax Advisory is a firm that specializes in Cost Segregation studies and Depreciation Recapture. We can help you take advantage of these tax benefits and plan for any potential recapture liability. Contact us today to learn more about how we can help you save on taxes.



The information provided in this blog is intended for general information only, and is not meant to constitute tax advice.

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