Rather than seeing a large percentage of profits go toward taxes, many investors may wonder if there is a way to avoid paying depreciation recapture tax, along with capital gain tax.
For example, some investors consider moving into a rental property and using the home as a primary residence for at least two years before selling. So, even though an investor may be able to avoid paying capital gains tax by using a rental property as a primary residence for a couple of years, the tax on depreciation recapture would still be owed when and if the primary residence is sold.
Turning a rental property into a primary residence may also be difficult for a remote real estate investor to do. For example, if an investor has a high-tech job in San Francisco, moving to a smaller market like Waco, Texas, to turn a rental property into a primary residence and save a few thousand dollars in tax may not be the most practical move.
However, both depreciation recapture tax and tax on capital gain can be deferred by conducting a tax deferred exchange. When a rental property is relinquished or sold and replaced with another investment property within days, an investor may avoid paying tax on depreciation recapture and capital gains.
In other words, deferred taxes on depreciation recapture and capital gains would eventually become due if the investor sold rental property without reinvesting the gains when he or she was alive. However, if an investor continues to own rental property until he or she passes away or drops , the heirs do not pay any deferred depreciation recapture or capital gains tax on an inherited property.
Instead, the property basis is stepped up for the heirs, which is how some real estate investors may be able to build generational wealth. Generally speaking, a rental property is put into service when it is ready and available to be rented, not when a tenant takes possession, according to IRS Publication After your first partial year of service, rental property is depreciated 3. At this point, you may be wondering if you can avoid dealing with rental property depreciation recapture simply by not claiming depreciation in the first place.
Unfortunately, the answer is no. Internal Revenue Code Section states that depreciation must be recaptured if depreciation was allowed or allowable. An IRC Section tax-deferred exchange is the process that allows real estate investors to defer the payment of capital gains taxes. Internal Revenue Code. This section of the Internal Revenue Code allows investors to sell or relinquish an investment property, reinvest the proceeds in a replacement investment property of like kind and greater or equal value, and defer the payment of any capital gains tax.
There are seven simple rules to follow that allow you to defer all capital gains tax:. In addition to deferring the payment of capital gains tax on investment real estate, there are a number of other advantages to a exchange:. With proper planning, you may be able to minimize your tax liabilities that result from recapturing depreciation or even defer paying any tax by conducting a tax-deferred exchange.
Jeff has over 25 years of experience in all segments of the real estate industry including investing, brokerage, residential, commercial, and property management. While his real estate business runs on autopilot, he writes articles to help other investors grow and manage their real estate portfolios. Free Property Valuation. Browse our rental property marketplace. Understanding Rental Property Depreciation Recapture in This gain is usually taxed as long-term capital gains, however, if during the last five years, you had accumulated Section losses, then part of this gain would be taxed as ordinary income.
In the example, the farmer sold the tractor for cash. Paul Neiffer is a certified public accountant and business advisor specializing in income taxation, accounting services, and succession planning for farmers and agribusiness processors. Paul is a principal with CliftonLarsonAllen in Walla Walla, Washington, as well as a regular speaker at national conferences and contributor at agweb. Raised on a farm in central Washington, he has been immersed in the ag industry his entire life, including the last 30 years professionally.
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