How does depreciation affect rental sales?

Homes being used for rental income must be depreciated by law. Depreciation is an income tax deduction that allows a taxpayer to recover the cost of building deterioration on an annual basis. However, it’s not just a “free” tax deduction…

​While depreciation may offset rental income gains each year, that deduction stays “on the books” and is accounted for when a home is disposed of/sold.
 
For example, a home with a $275,000 building value (for depreciation purposes) will have a $10,000 annual deduction on the tax return (rental homes are depreciated over 27.5 years). If a rental owner decides to sell the home after 5 years, there has been $50,000 of accumulated depreciation during this period. At time of sale, this depreciation is subject to being recaptured.
 
Depreciation recapture means the basis of the home must be reduced by the amount of depreciation taken over time, which can affect the corresponding income taxes due.
 
In the above example, if the home was purchased as a rental for $400,000 ($275,000 building value and $125,000 land value) and later sold for $700,000…one might assume the net gains are $300,000 minus selling costs. However, the $400,000 basis is actually reduced by the $50,000 accumulated depreciation amount, which brings the capital gains to $350,000 instead of $300,000. So in effect, the $50,000 in depreciation deductions taken over time are “recaptured” at the time of sale.
 
This portion of the gains is then taxed at the lesser of your effective tax rate, or the recapture rate.
 
For this reason, sellers of rentals are often surprised by the larger-than-expected capital gains. With that being said, passive loss carryovers may exist as well, which may help offset some of the gains and corresponding taxes.
 
Also, if a home is sold after being inherited from the original owners upon their passing, the cost basis of that home “steps-up” to current market value, thereby making depreciation recapture irrelevant.
 
We understand there’s a lot of “tax lingo” here and it may not be clear from reading, so please feel free to contact us any time with questions!