This is an excellent question. There are many taxpayers who do not fully understand exactly how depreciation works, how it reduces their income taxes by sheltering some of their rental income, and most importantly what happens to the depreciation when they ultimately sell their rental property without using the 1031 exchange.
Taxpayers must depreciate their rental property. It is not an option. The depreciation taxpayers have deducted on their income tax return during the time they owned the rental property must be recaptured or added back into their taxable income as depreciation recapture when they sell their rental property without structuring a 1031 exchange.
Depreciation Recapture Is Mandatory
It is extremely important to note that depreciation recapture taxes will be calculated and assessed by the Internal Revenue Service whether or not the taxpayer actually took (booked) depreciation on his or her income tax return, so taxpayers must always depreciate their rental properties even if they do not receive any immediate benefit from the depreciation.
Depreciation Recapture Income Tax Rates
The Federal and state income tax rates applied toward depreciation recapture can vary depending on when the property was placed into service and what depreciation method is being used. Depreciation recapture is taxed at a higher rate than capital gains.
Generally, Federal capital gains are taxed at a maximum income tax rate of 15% and depreciation recapture is taxed at a flat income tax rate of 25%, plus any applicable state or local income taxes.
Taxpayers should always have their tax advisors compute the actual amount of depreciation recapture as well as capital gains prior to completing any sale of rental property in order to avoid any unpleasant surprises when the file their income tax return.
Deferring Depreciation Recapture Income Taxes
Depreciation recapture, like capital gains, can not be avoided except by death, which is not a very effective or desirable tax planning strategy. Taxpayers can defer both by structuring a 1031 exchange and acquiring replacement property. The depreciation recapture and capital gains are deferred (transferred) into the newly acquired replacement property.
Defer Capital Gains Indefinitely
Unfortunately, capital gains and depreciation recapture taxes can only truly be avoided by the death of the taxpayer. The taxpayer continues to 1031 exchange throughout his or her lifetime and will therefore continue to defer the payment of his or her capital gain and depreciation recapture taxes indefinitely. The tax liabilities are continuously deferred throughout his or her lifetime, and they actually go away at his or her death because their heirs will receive a step-up in cost basis.
Step-Up In Cost Basis
The fair market value of the taxpayer's rental property is included in his or her estate and may be subject to estate taxes (inheritance taxes). Because the property is taxed as part of the estate at the fair market value at the date of death, the heirs will receive a "stepped up" cost basis upon death. The heirs cost basis becomes the fair market value of the rental property on the taxpayer's date of death.
Capital Gain and Depreciation Recapture Taxes Avoided
The capital gain and depreciation recapture taxes completely disappear and the taxpayer's heirs could immediately sell the property and pay no income taxes. In fact, they may even sell at a loss in the current market cycle and be able to write off a loss on the sale. They should consult with their income tax advisors to see how they would be affected.