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When you sell an asset, there are two types of gains that the Internal Revenue Service can use to charge you tax. Capital gains occur when you sell an asset for more than you paid for it. When you own a depreciable real estate asset, like a rental house, you can also be subject to tax on any sales proceeds greater than your depreciated value. This "unrecaptured 1250 gain" is taxed at a 25 percent rate.
Depreciating Rental Property
Since your rental house should last more than a year, the IRS doesn't let you claim the entire cost of buying the house as an expense in the year that you buy it. Instead, you write off the building's value over its useful life which, according to the IRS, is 27.5 years. For example, for a $300,000 house that consists of a $110,000 plot of land and a $190,000 house, divide the $190,000 by 27.5 to find the yearly depreciation deduction of $6,909. You can claim this amount for 27 1/2 years until you've fully written down the value of the house to nothing. This depreciation is a way to simulate the gradual wearing out of the building. Commercial property works the exact same way, but has a 39-year life instead of the shorter 27.5-year life for houses and apartment buildings.
As you depreciate property, it should lose value. So, if you've owned that house for 30 years, its book value will be zero, and it should, theoretically, be worthless. However, if you sell it for more than its book value, it means that it really didn't lose as much value as the IRS expected. Since it didn't really lose value, the IRS requires you to pay back the taxes that you would have paid if you didn't depreciate that portion of the house. Section 1250 requires you to pay a flat 25 percent rate on these gains, instead of your regular income tax rate or the capital gains rate.
Consider a house that you bought 10 years ago for $225,000, with the home valued at $175,000 and the land valued at $50,000. Today, you sell the house for $300,000, with the home valued at $240,000. The sale gives you a $75,000 profit on your original purchase, which is subject to capital gains tax. However, over 10 years, you've also claimed roughly $63,636 in depreciation. Since you sold the property for more than the depreciated value of $111,364, the entire amount of depreciation you claimed -- $63,636 -- is an unrecaptured 1250 gain, and, at 25 percent tax, gives you another $15,909 in tax liability. If, instead of selling the property for a profit, you sold it for $190,000, with the home valued at $140,000, you'd have a $35,000 capital loss. However, you'd still owe taxes. Since the home's value of $140,000 is $28,636 more than the depreciated value, you'd have to pay tax on that amount. While the $25,000 could offset other capital losses, you'll also have to pay $7,159 in recapture tax.
Avoiding Recapture Tax
You can't avoid recapture tax liability by not claiming depreciation. The IRS charges recapture tax based on the depreciation that you could have taken, even if you didn't take it. Other than selling your property for less than its depreciated value, the best way to avoid paying recapture tax is to sell your property and use the proceeds to buy more investment real estate property. If do this and set the transaction up as a 1031 exchange, you'll carry your basis forward to the new property. While this means that you won't be able to claim as much depreciation on the new property, it also means that you won't have the pay the recapture tax on the present sale. As long as you keep 1031 exchanging, you can keep carrying the basis and the tax liability forward.
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