With property values back to highs that haven't been seen in several years, many owners are looking to sell their rental properties. However, many are also feeling the pain of depreciation deductions on their taxes. If you own rental property or non owner occupied property, you probably were excited about being able to get a tax deduction for depreciation of your property. In fact, even if you weren't excited about it, the IRS required you to depreciate certain items. Many investors try to accelerate their depreciation and get greater tax write offs. This works fine, provided the investor has an exit strategy that will minimize the depreciation recapture tax the IRS collects when you resell the property.
What do I mean by this? When you write off depreciation over the course of time, that amount can add up to several thousand dollars. However, when you sell the investment property, the IRS looks at the sale of your property as though you recouped all of the depreciation and thinks of that as income to you. As a result, the IRS taxes those "recaptured" dollars, typically at rates of 25%.
Can't Afford to sell Because of Taxes?
I keep hearing, "We can't afford to sell the property because of depreciation recapture". Unfortunately, sooner or later one has to pay the recapture tax, with one exception. When you die, your property passes on to your heirs without any of the taxes. If your intent is to leave real estate as an inheritance, this is a great plan. However, if you are looking to move your investment dollars to a more liquid position, then you are faced with how to reduce your depreciation recapture tax. This requires the expertise of a qualified CPA with experience in this area.
Avoiding Depreciation Recapture Tax - 1031 exchange
There are a couple solutions to this problem. The most common solution is to do a 1031 Exchange. In a 1031 Exchange you trade one investment property for another. From an IRS viewpoint, you are trading your basis, what you have invested in the property and your depreciation, from one property to another. This means that the depreciation that has been accumulating for years transfers to the new investment property without being subject to the recapture tax.
The challenge with 1031 exchanges is the timing and complex rules sellers face. In an Exchange the seller must identify and close on the replacement property within the timelines established by the IRS. The sellers may have had a replacement property previously lined up. However, after their due diligence, they decide against the new property and begin looking for another. It is not uncommon to find a seller desperate to find a new replacement property because their 1031 time period is running out.
How to extend your 1031 exchange time window
Consider what would happen if your buyer allowed you to have a prolonged escrow. What if the buyers were willing to wait, 90-120 days to close? Under an extended escrow, the seller could take their time doing their due diligence on new properties. Once they had completed their due diligence, they could start the closing process on their original property. This wouldn't probably work for a typical end user who intends to live in the home; but it might work for a rehabber or investor who is moving up.
Timing and Cash Flow
However, what if you don't want to give up the cash flow from your rental, but don't want to deal with being a landlord/owner any more? And because home values are up, you want to sell now. In another post I give the following example of how an installment sale may be a better alternative in some cases to a 1031.
Example: Sue has a property that she originally paid $100,000 for and is now worth $200,000. The property has been fully depreciated and is subject to $25,000 in depreciation recapture. In addition Sue also owes taxes on her capital gains. Sue wants to sell this year because property values are high and so is demand. However, Sue is in high tax bracket this year and would like to reduce her taxes. She wants to defer the income from the sale of her rental property to years where she's likely to be in a lower tax bracket.
The installment sale - An alternative to 1031 exchanges
With Installment Sales, you can sell your rental property over time and spread out your taxes. Note, I did not say eliminate them simply spread them out. The process works similar to selling your property with you carrying back a loan to the new buyer. The benefit is that the depreciation recapture and the capital gains taxes are spread out.
Example: I'll continue with the example above. Sue sells her rental property using an installment sale that spreads the purchase over 5 years. Sue has a promissory note and Deed of Trust that protects her in the event her buyer fails to make the payments. By spreading the sale of her home out over 5 years, Sue defers some of her capital gains to later years when she will be in a lower tax bracket. She also spreads the depreciation recapture out over 5 years, so that each year she only has to pay $5,000.
Talk to your CPA
We are not tax advisors or CPAs. Please make sure to talk to your CPA about these options if you are considering any of these concepts. The intricacies of tax law are too complex to discuss here in this short of time.