Exit Strategies, Capital Gains, and Depreciation Recapture

This article continues the focus on tax advantages inherent to investment real estate.  The last article, Part 1 of this series,  covered depreciation over the life of the investment.  Here, we are focused on the the mid-term to discuss  returns and taxes upon selling the asset.

Long Term Capital Gains Treatment

First let’s look at the long terms capital gains treatment of investment real estate using a case study.

We’ll use the same numbers from Part 1:

–          $100K house, with $20K down

–          $80K bank loan

–          5.5% interest

–          $3000 annual cash flow

–          $2909 annual depreciation deduction

Many investors look for a passive investment with a 5-10 year hold strategy.  Over that period, two things happen that affect long term tax advantages.  The first is appreciation; the appreciation is subject to capital gains.  The second is depreciation recapture tax.

Appreciation and Capital Gains

To determine capital gains, we need to know how much the home appreciated.   Let’s take a conservative appreciation of around 4%.  So the original  $100K house is now worth $150K or

$100,000 X ~4% appreciation X 10 years = $150,000

The value of the house increased $50K.  So $50K is the taxable capital gain.

On that $50K appreciation, you must pay capital gains tax of 15% of 50K or $7,500

 

This 15% tax treatment is calculated at the long term capital gains rate. For many people, especially in the mid to  upper tax brackets, long-term capital gains tax is generally a lower percentage than income tax.  As an example, if you received $50K in income and  fall in the 28% bracket,  you’d pay  $14,000. Alternately, the capital gains tax  on your investment real  estate  is only  $7,500. This savings, in addition to depreciation, helps shelter your investment funds from tax, and frees up more capital for reinvestment during both the hold and sell period.

 

Depreciation Recapture Tax

 

Over a 10 year hold period, you will have been able to depreciate the property across those ten years for a total depreciation deduction of:

$2909 X 10 = $29,090

That means that across 10 years, $29K of the$80K in structure value has been depreciated. Now suppose you sell the house, and didn’t do anything else.

But government also knows that you had depreciated $29K over 10 years, so they have a depreciation recapture tax that is 25% under current law.  $2900 per year for 10 years = $29,000 X 25% = $7250

So you are going to pay a flat 25% depreciation recapture tax of $ 7250

The deferred depreciation recapture tax illustrates the pay now vs. pay later opportunity with investment real estate.  In this way, real estate shares this benefit with other, more volatile investments (e.g. stocks).

At the end of the day, it is better to pay the capital gains and depreciation taxes 10 years from now.  Tax deferral allows you to use and invest that money in the 5-10 year hold period leading up to your exit.

See the next post on how to defer capital gains and depreciation recapture tax indefinitely through a 1031 Exchange.

To refer back to our series please see the links below:

Part 1: Shield Your Investment

Part 2: Capital Gains & Depreciation

Part 3: 1031 Exchange