You were probably already aware of the capital gains tax when you purchased your rental property investment . That you might be required to pay it to the Feds in the year when you outright sold your investment property without involving a Section 1031 tax deferred exchange.

You might not know, however, about the depreciation recapture tax you will also have to pay the Feds, and may be in for an unpleasant surprise when you discover that your sales proceeds are lower than you anticipated by virtue of a higher federal obligation.

What is depreciation recapture tax?

First, understand that capital gains tax and recapture tax occur only when investment real estate is sold after one year of ownership. Profits on an investment property sold one year or less is classified as a short-term gain and taxed as ordinary income. Capital gains and the apply only to investment property held for more than one year. In real life, here is how it works. When you sell an investment property you have held for more than one year and have a recognized gain, the IRS, in addition to charging you a capital gains tax, will also tax you for the accumulated depreciation you took during the years you owned the property.

Say, for instance, you sell an office complex after ten years of ownership and make a taxable profit (gain) of $300,000, but during that time took $30,000 in depreciation. You must pay two taxes: the recapture tax on the depreciation first, and then the capital gains tax on the remainder.

Here is where it gets ugly.

The rate is currently higher than the capital gains tax rate (25% compared to 15%). As a result, you pay 10% more on the depreciation then you do if the recapture tax did not exist and your full profit was simply taxed as capital gains. This might be acceptable if you plan ahead for it, but extremely disappointing when you discover at tax time that you owe the IRS $3,000 more then you anticipated. Say goodbye to the high-definition plasma screen television you planned to purchase with your sale proceeds.

Unfortunately this scenario is not uncommon. More then once, real estate investors were not aware of the depreciation recapture tax and got burned. That is why we mention it, and hope (now that you do know it) you will fare better.

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