Depreciation recapture is a significant factor in participating in a like-kind exchange. While capital-gains tax rates are currently at historical lows, tax rules require you to recapture the portion of the gain on the sale that relates to allowable depreciation over the period the asset was held. Additionally, you must recapture it at a higher tax rate (typically 25%).
For the purpose of discussion, the depreciation recapture rules assumes that: (a) your regular marginal income tax bracket is greater than 15%, and (b) the real estate sold is the only business asset sold by you in the tax year of the sale.
Generally, the gain from the sale by a non-corporate taxpayer of real estate that is a capital asset (or is used in a business) and is held more than 12 months is not taxed at a rate higher than 15%.
However, a more complex set of rules comes into play when the asset sold is depreciable real estate. This is so because, in that case, a maximum rate of 25% will apply to “unrecaptured Section 1250 gain”, and a maximum rate of 15% will apply to the balance of the gain. Unrecaptured Section 1250 gain refers to the portion of gain that is eligible for capital gains treatment even though it is attributable to previously allowable depreciation. A further complication is that the portion of the gain that is unrecaptured Section 1250 gain depends, as shown below, on when the property was placed in service.
Property placed in service after 1986
For real estate placed in service after 1986, all depreciation deductions allowable before the sale of the real estate give rise to unrecaptured section 1250 gain. For example, if you sell a building at a gain of $2,000,000 on which $900,000 of depreciation deductions were allowable to you through the time of sale, $900,000 of the gain is unrecaptured Section 1250 gain that will be taxed at a rate of 25%. The remaining $1,100,000 of the gain will be taxed at a rate of 15%.
Property placed in service between 1981 and 1986
For real estate placed in service after 1980 but before 1987, the treatment of gain on sale depends on whether the real estate is residential or non-residential.
Residential Real Estate
If you depreciated residential pre-1987 realty using straight-line depreciation, the tax result from the sale will be the same as for a sale of post-1987 property, as described above. But if (as was possible) you, at any time, used a declining balance method to depreciate the real estate, the gain on sale would be taxed as follows:
- Gain, to the extent of the depreciation claimed that exceeds what would have been allowable under straight-line depreciation, will be recaptured as ordinary income, and, thus, taxed at rates as high as 35% in 2003 and later years (ordinary income rates), but the amount of excess depreciation subject to recapture may be less for certain low-income housing.
- Gain, to the extent of the depreciation that isn’t recaptured as ordinary income, will be taxed at a rate of 25%.
- The balance of the gain will be taxed at a rate of 15%.
- Example – In January 1986, you paid $1.3 million for an apartment building (not a low-income building), of which $1 million was allocated to the improvements. You depreciated the property using the 175% declining-balance method. You sold the property in July 2003 for $2 million. From 1986 through 2003, a total of $915,750 in depreciation was claimed. Assuming the only adjustment to basis was for depreciation, there would be a gain of $1,615,750 ($2 million less remaining basis of $384,250), taxed as follows:
- $19,583 (the excess of $915,750 depreciation claimed over $896,167 that would have been allowable using straight-line depreciation) would be taxed as ordinary income;
- $896,167 (the depreciation that isn’t recaptured as ordinary income) would be taxed at a rate of 25%;
- $700,000 (total gain—$1,615,750 less $915,750 ($896,167 + $19,583) would be taxed at a rate of 15%.
Non-residential Real Estate
As is the case for residential pre-1987 real estate, if you depreciated non-residential pre-1987 real estate using just straight-line depreciation, the tax results for a sale will be the same as for a sale of post-1986 property, as described above. But if, as was possible, you, at any time, used a declining-balance method to depreciate the realty, the gain on sale would be taxed as follows:
- Gain, to the extent of the full amount of depreciation allowable to the time of sale, would be recaptured as ordinary income, and, thus, taxed at ordinary income rates;
- The balance of the gain would be taxed at a rate of 15%.
- Example – Assume the same facts as in the example above, except that the $1.3 million building is a commercial building. The gain is the same, $1,615,750, but would be taxed as follows:
- $915,750 (representing all of the depreciation allowable) would be taxed as ordinary income;
- $700,000 (the balance of the gain) would be taxed at a rate of 15%.
The following rules apply if you sell real estate placed in service before 1981:
- The excess of depreciation claimed over straight-line depreciation is recaptured as ordinary income, and thus taxed at ordinary income rates (but the amount of excess depreciation subject to recapture may be less for certain residential real estate or for real estate acquired before 1970).
- Gain, to the extent of the balance of depreciation allowable, is unrecaptured Section 1250 gain, taxed at a rate of 25%.
- The balance of the gain, if any, would be taxed at a rate of 15%.
Please remember, every investor faces a unique set of tax considerations. If you have further questions about the above rules, or would like to compute your potential tax liabilities, please contact your tax advisor.
Information and examples provided herein are for educational purposes only. Individual circumstances and results will vary.
According to Regulation §1.1245-2(b), a taxpayer is generally required to report all gains or losses on the disposition of capital assets – including the transactions affecting capital gains or losses – in a separate computation on the tax return (Reg. §1.1202-1(a)). However, there is no statutory authority that requires the reporting of a full tax-deferred exchange. You should consult with your tax advisor on whether you should attach a schedule to your tax return. Attaching the schedule starts the clock on the statute of limitations – if there is a problem.
Schedule D and Form 4797
An exchange of like-kind property may be reported on Schedule D or on Form 4797, whichever applies. The instructions to Schedule D (Form 1040) state that all exchanges must be reported. The instructions apply to even fully tax-deferred exchanges. Again, there is no statutory authority for this instruction, but it does present a dilemma. Those who are more aggressive in their tax compliance will probably continue to report as little as possible while conservative advisors will usually recommend reporting the exchange even where no tax is generated, in order to start the on the statute of limitations. If you choose to report the exchange, keep it as simple as possible. A short “memo box” recapitulation on a single sheet of paper can suffice and be attached to Schedule D or Form 4797.
If you have a like-kind exchange, you must file Form 8824 – Like-Kind Exchanges –in addition to Schedule D or Form 4797. Form 8824 requests specific information about the exchange including:
- Descriptions of the properties;
- Date of disposition of taxpayer’s property;
- Dates of identification and acquisition of the replacement property;
- Certain related party information. The balance of the form concerns computations of realized gain or loss, recognized gain, basis of property received, and deferred gain.
Examples used are for hypothetical purposes only and do not indicate suitability for one particular investor.