For many of our clients who hold rental properties, the term “depreciation recapture” can come across a bit mystifying, upon the sale of their property.
Whilst the term can be confusing, the impact it has on a tax return is actually quite basic.
As we know, US citizens are required to report their worldwide income to the IRS each year, through a US tax return. This includes all NZ or Australian income, regardless of whether the taxpayer has ever earned any income whilst physically in the USA.
This reporting also includes any rental income generated from properties, even those located outside of the US.
Whilst US taxation of overseas rental property income is rare (due to Article 6(1) of the NZ-US double taxation agreement), the income and expenses of a rental still need to be reported to the IRS. Under Article 6(1), the country where the property is physically located has the first right to tax rental income, with the other country (US) allowing a foreign tax credit for tax paid locally.
As part of determining rental income and expenses, depreciation of the property is also calculated. Depreciation is claimed as an expense against rental income.
For rental properties placed in service before 1st January 2018, the property is depreciated over a 40 year timeframe. Properties placed in service from 1st January 2018 onwards, are depreciated over a 30 year timeframe.
To be clear, “placed in service” means when a property is made available for rent, regardless of whether it is actually tenanted immediately.
For those unfamiliar with what depreciation actually is, this is the gradual chipping away of the basis of the property, despite the fact that property values (in NZ at least) generally tend to only go up.
But what is basis? From an IRS perspective, basis is either:
For a newly purchased rental – The purchase price, plus legal fees and improvements to the property
For converted rentals (ie a family home converted to a rental) – Either the purchase price as above, or the fair market value on the date of conversion, whichever is lower
Basis is also used to determine capital gains upon the sale of a property, which means any sale price above your basis will be considered a capital gain (and taxable by the IRS). As you can see, for properties which are converted to a rental midway through your ownership, there is a risk that your basis could drop if market values are lower than the original purchase price.
We’ll also briefly explain that the IRS has two different types of tax:
Capital gains tax – Generally taxed at a lower rate 15%
Ordinary income – Taxed at a higher rate, dependent on your tax bracket, up to a maximum of 37% for 2021
Now, finally on to Depreciation Recapture…
Lets say a rental property was purchased by a US citizen (in NZ) for $400,000 USD equivalent including legal fees and improvements, and placed immediately in service, on 1st January 2012.
We know from the above that the basis of the property is $400,000, and it is subject to 40 year depreciation.
Each year, $10,000 of property value is depreciated as an expense against rental income.
On 1st January 2022, the property will be sold for $500,000 USD equivalent, we now have to deal with depreciation recapture.
Over the 10 years, $100,000 of depreciation has occurred, meaning the basis of the property is now $300,000 (assuming no improvements were made). We now have a $200,000 capital gain ($500k sale price less $300k basis).
But, this $100k of depreciation must now be recaptured. So of our $200k gain, we’ll have:
$100,000 taxed as a capital gain (15%)
$100,000 depreciation recapture, taxed as Ordinary Income (maximum rate of 37%)
And here we have it, the depreciation claimed over the last 10 years has been caught back by the IRS and taxed at heavier Ordinary Income tax rate.
It is important to note, that depreciation recapture occurs regardless of whether depreciation was actually claimed. In the case of an individual who hasn’t been filing tax returns, upon the sale of a rental, depreciation recapture will still calculate depreciation for all the years that no return was filed, despite no actual depreciation benefit being claimed.
Please note, the above is heavily generalized, and should not be used as formal tax advice in any way. Personalised tax advice should always be sought before engaging in any taxable transaction.