How to Avoid Depreciation Tax on Rental Property

It can pay to be a responsible rental property owner. For instance, if you’re always investing in your rental property and making improvements, not only will your tenants appreciate it and remain tenants longer, you can get a depreciation deduction on your taxes. Unfortunately, upon selling the property, depreciation sometimes becomes a migraine for landlords in the form of a depreciation recapture tax. You have options, however, to avoid depreciation recapture tax.

If you need help with taxes, a financial advisor can help you create a tax strategy.

What Is a Depreciation Recapture Tax?

The depreciation recapture tax is the difference between a rental property’s sale value and its depreciated value. This is extra income that will be taxed on your next tax return, after selling the property.

In other words, the IRS is “recapturing” what they see as lost taxable income. This is a tax that the IRS collects, assuming that one has sold the property for a profit. And also assuming that it has received a depreciation deduction over the years.

How to Avoid Depreciation Tax on Rental Property

If it’s important to you to avoid the depreciation recapture tax, there are several strategies you may want to adopt:

Conduct a 1031 exchange. This is a strategy that allows you to defer paying capital gains tax on the sale of an investment property – provided you use the revenue earned to purchase another similar property. There are a lot of onerous rules to follow to profit from this strategy, but it may be worth investigating and discussing with a financial advisor.
Pass on the property to your heirs. When your children or grandchildren someday sell the property, they will not inherit a deferred depreciation recapture tax or a capital gains tax. They may create their own tax issues, of course, if they rent out the property themselves.
Sell the property at a loss. That may not be appealing, but it is a way to avoid the depreciation tax on a rental property.

Why Land Isn’t Considered a Depreciable Asset

A paper showing the word "depreciation."

The IRS’s policy is that a depreciation recapture tax affects doesn’t affect your land but only the property, like a house or building. Those often will go down in value unless it is maintained and improved.

In other words, the IRS treats rental property like any other business asset. That can include items like a delivery van or a desktop computer. For a residential building, the IRS allows a property owner to depreciate it over 27.5 years.

To calculate how much you can deduct each year, you divide your property’s cost basis by the useful life of the asset to get the annual amount of depreciation.

(Incidentally, that 27.5 is the federal government’s number; if you’re working out the depreciation recapture tax for your state’s taxes, you may be working with another number.)

Example of Depreciation Recapture Tax

Let’s say that you purchased a house for $300,000, and then you had tenants living there for a decade. After that, you decide to sell the property. Divided by 27.5, a rental property owner could take a depreciation deduction of $10,909 a year. (That’s $300,000 divided by 27.5.) And then 10 years later, if they sell their property for $500,000, they may have taken $109,090 in depreciation deductions.

In this case, the IRS would tax the remaining $390,910 ($500,000 minus $109,909) at a short-term or long-term capital gains rate. And that rate is anywhere from 0% to 37%.

(The percentage the rental owner receives depends on factors such as the property owner’s income and tax bracket and how long they’ve owned the property.)

The total depreciation deductions ($109,090) will be taxed at a recapture rate that can go as high as 25%.

Sometimes the deprecation recapture tax can cause a tax bill to be much higher than a property owner expected. And that’s when some people look for an escape hatch that can reduce their tax bill. Fortunately, there are some options.

When Depreciation Recapture Doesn’t Apply

Depreciation recapture affects many rental property sales, but there are a few situations where landlords may not owe it:

Selling the property at a loss. If you sell the rental property for less than its adjusted basis, you won’t owe depreciation recapture. Recapture only applies when you sell at a gain, since the IRS is “recovering” the tax savings from your depreciation deductions. Keep in mind, however, a loss may be subject to its own tax rules.
Converting a rental to your primary residence (with caveats). Living in the property before selling it may qualify you for the Section 121 exclusion, which can reduce or eliminate capital gains. However, this does not erase the depreciation recapture portion. You’ll still owe recapture on any depreciation taken during the years it was a rental, but you may reduce the rest of your taxable gain depending on how long you lived there.
Not claiming depreciation doesn’t eliminate recapture. Some owners think skipping depreciation deductions will help them avoid recapture later, but this is a common misconception. The IRS assumes you took the full allowable depreciation whether you claimed it or not, meaning the recapture tax still applies.
Certain trust-owned properties. In some estate or trust arrangements, depreciation recapture may not apply if the property receives a step-up in basis at death. For example, when a property passes through a properly structured trust or directly to heirs, the basis resets to the fair market value at that time, effectively wiping out prior depreciation and eliminating the associated recapture. However, gifting a property during your lifetime generally does not qualify for this benefit.

Knowing when recapture applies and when it doesn’t can help you plan ahead, avoid unpleasant tax surprises and decide which strategy is best for your long-term goals.

Bottom Line

A small model house and bag with a dollar sign on it.

For some property owners, the deprecation recapture tax will likely not cause a lot of headaches. But it may be for others, especially those in high tax brackets with valuable assets and a lot of depreciation deductions. However, before you make any rash decisions about selling your property or leaving it to your beneficiaries, it would be a good idea to discuss your next move with either a financial advisor a licensed tax professional, or both.

Tips for Calculating Your Taxes

Whether you need help with retirement planning, estate planning, tax planning or investment portfolio organization, a financial advisor can help. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
If you don’t know whether you’re better off with the standard deduction versus itemized, you might want to read up on it and do some math. You might find that you’d save a significant amount of money one way or another. So it’s best to educate yourself before the tax return deadline.