Is Depreciation a Double-Edged Sword When Selling a Rental Property? 

When it comes to investing in real estate, it’s normal to come across complicated financial concepts, and depreciation is one of them. However, in rental property sales, depreciation can be a double-edged sword as it can significantly impact your taxes and profitability.

One thing depreciation does is provide a tax benefit that allows property owners to annually deduct a chunk of their property’s value. This deduction can help balance rental revenue, thus lowering taxable profit. That’s why you should keep track of depreciation on your rental property to offset income and reduce tax liability.

Continue reading below, as this post discusses everything you need to know when it comes to depreciation’s role in rental property sales.

How to Calculate Rental Property Depreciation

Calculating rental property depreciation requires some math, but don’t worry, it’s not difficult. Below, we’ll break down how to calculate the amount of real estate depreciation on a rental property. However, we recommend working with a tax professional or a property management firm because the process might be a bit complicated.

Calculating the Cost Basis

The cost basis is the amount you paid for the property. It considers some specific fees, such as the closing costs, but generally, it considers every penny you spent to obtain your property.

However, some charges, such as insurance payments, can’t be included in the property’s cost basis. For example, if you purchased your property for $400,000 and paid $9,000 in closing costs, your cost basis would be $409,000.

It’s important to note that you may have to adjust your cost basis if you can’t immediately put your property in service, like renting it out. For example, if it took some time before you could put your property on the market, you’ll probably have to increase or reduce your cost basis. Professional Property Management of Northern Virginia can assist landlords in organizing and tracking depreciation before selling.

Dividing Cost Basis by Useful Life

Now that you understand the cost basis, its time to divide it by the useful life. The valuable life refers to the number of years a property is considered usable. The useful life of residential property under the General Depreciation System (GDS) is generally 27.5 years. The GDS states that the useful life for residential rental units is 27.5, so with that kept in mind, the calculation would be: $409,000 / 27.5 = $14,872.72.

In this case, you’d be able to deduct $14,872.72 in property depreciation per year. Also, notice that if you own multiple rental properties, you must record depreciation for every property separately. However, this process can be stressful, so hiring a property management agent to assist you during tax time wouldn’t hurt.

3 Ways to Avoid Depreciation Recapture Tax

Check IRS Section 121 exclusion

Section 121 Exclusion, often known as the principal residence tax exclusion, allows people who sell their primary houses to invest the proceeds in another home without paying taxes on the gain. To claim the exclusion, the proceeds from a home sale do not have to be used to buy another house.

Conversely, the exclusion is designed to limit similar tax benefits to investors who invest in rental properties. People who sell secondary residences, such as holiday homes, are also not eligible for the exclusion. It is also often unavailable to individuals who frequently purchase and sell their primary homes. The exclusion also does not apply to property used in a trade or business. Finally, U.S. taxpayers are eligible for the principal residence tax exclusion if the principal residence is located outside the United States.

Conduct 1031 exchange

Conducting “1031 Exchange” is a popular strategy among real estate investors and relates to Internal Revenue Code section 1031. It effectively allows you to trade your real estate for another investment. This swap provides for the deferral of capital gains taxes. Both properties must be similar to be called a “like-kind exchange.” This transaction is a trade, not a sale; thus, there are no taxable capital gains.

A 1031 Exchange includes costs, strict timelines, and specific requirements. Despite this, it is still one of the greatest ways to avoid capital gains and depreciation recapture tax.

A drawback of the 1031 Exchange is that you do not receive a cash settlement on the trade of the property. So, if you’re short on funds, you may decide to sell your property and deal with the taxes later.

Sell the Property at Loss

Avoiding depreciation recapture tax can be tricky, but there are approaches to soften the blow. Selling your property at a loss is one of them. When you sell for less than the adjusted basis, you can offset the recaptured depreciation against the loss, potentially decreasing or, better still, eliminating your tax liability.

However, this tactic requires careful consideration of market conditions and financial implications associated with this decision. Additionally, exploring alternative tax-deferral strategies, such as the 1031 exchange or converting the property into a personal residence, can offer viable alternatives to mitigate depreciation recapture taxes.

Conclusion

Depreciation can be a two-edged sword when selling a rental property. While it can offer you tax benefits during ownership, it can reduce the property’s basis and potentially result in higher capital gains taxes when sold. However, when you implement strategic planning, such as using 1031 exchanges or seeking the property at a loss, this may assist with minimizing the negative impact.

Investors should consider the long-term rewards and prospective tax consequences to make informed decisions regarding this. You may efficiently negotiate this part of property ownership by understanding depreciation and applying smart financial strategies that maximize revenues while avoiding tax liabilities.