Depreciation Recapture Tax Adjustments for 2024

Depreciation Recapture Tax Adjustments: What Real Estate Investors Should Know in 2024

For real estate investors, landlords, syndicators, flippers, and wholesalers, depreciation is one of the most powerful tax-saving tools available. However, while depreciation offers significant deductions during the ownership of a property, it comes with a catch when the time comes to sell. This catch is known as depreciation recapture, and it can result in an unexpected tax liability when a property is sold.

With potential changes to tax policies in 2024, understanding depreciation recapture tax adjustments is more important than ever. This article explores what depreciation recapture is, how it works, what changes investors may see in 2024, and strategies to manage depreciation recapture taxes effectively.

What is Depreciation and Depreciation Recapture?

Depreciation allows property owners to deduct a portion of the cost of their property each year, based on the idea that the property’s value declines due to wear and tear over time. Residential rental properties, for example, can be depreciated over 27.5 years, and commercial properties over 39 years. These deductions lower the property owner’s taxable income and provide significant tax relief during the years they own the asset.

However, when the property is sold, the IRS requires that any depreciation deductions taken during ownership be “recaptured” and taxed as ordinary income—this is called depreciation recapture.

Here’s how it works:

(a) Depreciation lowers the property’s adjusted basis, which is the property’s original cost minus any depreciation deductions.

(b) When the property is sold, the IRS taxes the recaptured depreciation at a maximum rate of 25%, while any additional gains are subject to capital gains tax at a lower rate.

For example, if you bought a property for $500,000 and claimed $100,000 in depreciation, the adjusted basis would be $400,000. If you sold the property for $600,000, you would have a $200,000 gain, of which $100,000 is subject to depreciation recapture tax, and the remaining $100,000 is subject to capital gains tax.

Changes to Depreciation Recapture Tax in 2024: What’s on the Horizon?

While depreciation recapture tax has long been set at a maximum rate of 25%, some changes could be on the horizon in 2024. These changes could significantly impact real estate investors, especially those who hold long-term rental properties or commercial real estate. Here’s a look at some of the potential adjustments:

1. Increased Recapture Rates: There are ongoing discussions about increasing the recapture tax rate for high-income earners. If this rate is adjusted upward, investors who have benefitted from years of depreciation deductions could see a larger tax bill when they sell their property. This would particularly affect investors with large portfolios or those selling high-value commercial properties.

2. Expanded Definition of Depreciation Recapture: Some tax reform proposals suggest expanding the types of property improvements that are subject to depreciation recapture. Currently, depreciation applies to structures, but changes might include improvements to the land itself or non-structural enhancements, broadening the tax base.

3. Changes to 1031 Exchange Rules: The 1031 exchange allows investors to defer paying capital gains and depreciation recapture taxes by reinvesting the proceeds from a property sale into a “like-kind” property. However, there has been talk of limiting 1031 exchanges, either by capping the amount of gain that can be deferred or eliminating the deferral for high-income taxpayers. If these changes are enacted, real estate investors will have fewer ways to defer recapture taxes.

Impact on Different Types of Investors

Landlords:

Landlords, particularly those who have held properties for decades, may face a significant tax bill upon selling their properties due to depreciation recapture. If the recapture rate increases or if changes to 1031 exchanges are made, landlords may find it more difficult to defer taxes.

Syndicators:

For syndicators managing large real estate portfolios, depreciation is an essential part of maximizing investor returns. Syndications often rely on 1031 exchanges to defer taxes when selling properties, so any changes to recapture rates or the 1031 exchange could impact their ability to deliver tax-efficient returns to investors.

Flippers:

While property flippers typically deal more with short-term capital gains, they can still be affected if they depreciate a property before selling it. Flippers who hold properties longer than a year may use depreciation to offset their rental income, but recapture could limit the tax benefits of this strategy when selling the property.

Wholesalers:

Wholesalers are less affected by depreciation recapture, as they generally deal in contract assignments rather than holding properties. However, wholesalers looking to shift into buy-and-hold strategies should be aware of how depreciation and recapture can affect their overall tax liability.

Strategies to Manage Depreciation Recapture Taxes

While depreciation recapture taxes are unavoidable for most investors, there are several strategies you can use to mitigate their impact.

1. Utilize a 1031 Exchange:

One of the most effective ways to defer depreciation recapture tax is through a 1031 exchange. By reinvesting the proceeds from a property sale into a similar property, investors can defer both capital gains and depreciation recapture taxes indefinitely. However, with potential changes to the 1031 exchange on the horizon, investors should act quickly and consult with tax professionals to ensure compliance.

2. Hold Properties Longer:

Another option is to continue holding properties and delay the sale. Depreciation deductions can offset rental income, making holding properties for longer periods advantageous from a tax perspective. However, it’s important to evaluate whether continued ownership aligns with your investment goals.

3. Invest in Opportunity Zones:

The Opportunity Zone program provides investors with the chance to defer or even eliminate capital gains taxes, including depreciation recapture, by reinvesting in designated low-income areas. Investors who hold these investments for a minimum of ten years can exclude capital gains from the sale of the Opportunity Zone property, creating a powerful tax-saving strategy.

4. Consider Cost Segregation:

Cost segregation allows investors to accelerate depreciation deductions by breaking a property into various components (e.g., flooring, appliances) that have shorter depreciation lifespans. While this increases the total amount of depreciation, it can also speed up the recapture process. However, this strategy is effective for investors who plan to reinvest proceeds into a new property via a 1031 exchange, as it maximizes deductions while deferring recapture taxes.

5. Offset Gains with Losses:

If you have other investments that have declined in value, you can sell them to generate capital losses, which can offset your capital gains, including depreciation recapture. This strategy, known as tax-loss harvesting, helps minimize your overall tax burden.

Impact of Depreciation Recapture on Real Estate Syndications

For real estate syndicators managing large portfolios, depreciation is a critical element of increasing investor returns. Syndications typically provide investors with passive income, and depreciation often offsets much of this income, making the investment more tax-efficient. However, when the property is eventually sold, syndicators must account for depreciation recapture, which can significantly reduce investor profits.

Syndicators need to carefully plan their exit strategies and consider how changes to depreciation recapture tax might impact their ability to provide strong returns. One potential strategy is to structure syndications with longer holding periods or look for opportunities in Opportunity Zones or other tax-advantaged investments.

Preparing for Depreciation Recapture Tax Changes

Depreciation recapture tax is an inevitable part of the real estate investment cycle, but understanding how it works and planning for it can help you minimize its impact on your profits. With potential changes to tax rates and rules coming in 2024, now is the time to review your investment portfolio and consider your options for mitigating taxes.

By utilizing strategies like 1031 exchanges, tax-loss harvesting, and cost segregation, investors can minimize their recapture tax liabilities and maximize the benefits of depreciation. For syndicators and other large-scale investors, these strategies are especially critical to maintaining profitability in a changing tax environment.

As always, it’s essential to consult with a tax advisor or financial planner who specializes in real estate to ensure that your investment strategies are optimized for both current and future tax laws. By staying proactive and informed, you can continue to build wealth through real estate while minimizing your tax burden.