Investing in multifamily real estate is a proven strategy for building generational wealth, offering steady cash flow and long-term appreciation. One of this investment approach’s most powerful yet often overlooked advantages is leveraging tax benefits—especially through depreciation.
When purchasing a new property investors typically use asset depreciation to offset tax liability. Depreciation allows investors to reduce taxable income derived from the property by reducing the asset’s value by accounting for natural wear and tear. To calculate the amount of depreciation an owner can take annually: take the purchase price minus the land value and divide by 27.5 years (its useful life). This deduction can significantly boost cash flow over time. However, if this property is sold for more than its adjusted basis, investors face depreciation recapture, a tax on the previously claimed depreciation.
Understanding how depreciation recapture works is essential for maximizing profits and minimizing tax liability. In this article, we’ll explain depreciation recapture, how it impacts multifamily investors, and strategies to manage it effectively.
What Is Depreciation Recapture?
Depreciation recapture is a tax provision that applies when an investor sells a property for more than its adjusted basis—the original purchase price minus accumulated depreciation. During ownership, investors typically use depreciation to lower their taxable income by deducting the property’s wear and tear, which increases cash flow and overall returns. However, when the property is sold at a gain, the IRS “recaptures” those tax savings by taxing the depreciated amount, typically at a higher rate than long-term capital gains. Savvy investors take advantage by strategically timing property sales, using 1031 exchanges to defer taxes, or reinvesting gains into higher-yielding assets.
How Does Depreciation Benefit Real Estate Investors?
Depreciation is a powerful tax deduction that allows real estate investors to lower their taxable income. Multifamily property investors can offset rental income by deducting a portion of the property’s value each year, significantly reducing their overall tax burden. For example, if an investor has a multifamily property valued at $2 million, they can depreciate the building (excluding land) over 27.5 years, resulting in substantial annual deductions. In multifamily syndications and private equity investments, these depreciation benefits are passed through to investors, allowing them to enjoy tax-advantaged cash flow while building long-term wealth. This strategy preserves more income and enhances overall investment returns.
When Does Depreciation Recapture Apply?
The IRS reclaims some of the tax benefits previously received by investors through depreciation deductions. In multifamily syndications, investors face depreciation recapture when the partnership sells the property and distributes profits. The recaptured amount is taxed like regular income up to the total depreciation claimed, while any extra profit is taxed at the capital gains rates. Key thresholds for triggering recapture depend on the property’s sale price, depreciation taken, and any improvements made, making strategic planning essential to minimize tax liability.
What Triggers Depreciation Recapture?
Key thresholds that trigger depreciation recapture are primarily based on the difference between a property’s sale price and its adjusted basis. Specifically, depreciation recapture is triggered when:
- Sale Price Exceeds Adjusted Basis:
If a property is sold for more than its adjusted basis (original purchase price + capital improvements − accumulated depreciation), the IRS requires investors to “recapture” the depreciation deductions previously taken. - Amount of Depreciation Claimed:
The total depreciation deducted over the holding period directly impacts the amount subject to recapture. The IRS taxes this portion as ordinary income (up to a maximum rate of 25%) rather than the lower capital gains rate. - Capital Improvements vs. Maintenance:
Significant capital improvements (e.g., adding new units or major renovations) increase the adjusted basis and can reduce the amount subject to recapture. Routine maintenance does not impact the adjusted basis. - Property Type Classification:
For residential rental properties (like multifamily real estate), the IRS uses a 27.5-year depreciation schedule. The longer a property is held, the more depreciation is claimed, increasing potential recapture. - Ownership Structure:
In multifamily syndications, when the partnership sells the property, the recapture amount is passed through to individual investors based on their ownership share. This can lead to higher personal tax obligations upon sale.
By understanding these thresholds, investors can strategically plan for sales, reinvestment, or tax deferral strategies like a 1031 exchange to minimize depreciation recapture taxes.
How to Calculate Depreciation Recapture
Calculating depreciation recapture involves a clear, step-by-step process that ensures investors understand their tax liability when selling a property. First, determine the adjusted basis by subtracting the total depreciation claimed from the original purchase price plus any capital improvements. Next, subtract the adjusted basis from the property’s sale price to identify the total gain. The portion of the gain equal to the depreciation claimed is taxed as ordinary income (up to 25%), while any remaining gain is taxed at the capital gains rate.
Break Down of the Above Example
If a person invests $ 1.5 million into a multifamily property, claims $200,000 in depreciation, and sells it for $1.5 million, the adjusted basis would be $800,000 ($1 million – $200,000). The total gain is $700,000 ($1.5 million – $800,000), with $200,000 taxed as depreciation recapture and the remaining $500,000 taxed at the capital gains rate. This calculation is essential for investors to accurately anticipate tax obligations and plan profitable exit strategies.
Tax Implications of Depreciation Recapture
Understanding depreciation recapture is crucial for multifamily investors aiming to maximize their returns. While long-term capital gains are typically taxed at lower rates (0%, 15%, or 20% based on income), depreciation recapture can be taxed at higher rates capped at 25% in 2024 and 2025. The IRS classifies the portion of profit related to depreciation as “unrecaptured Section 1250 gain.” If straight-line depreciation was applied during ownership, this gain wouldn’t be taxed as ordinary income but is subject to the Section 1250 tax rate. When a multifamily property sells for more than its adjusted basis, investors must repay the tax benefits received from depreciation deductions. For syndication investors, this tax obligation can significantly influence overall profits.
For instance, if an investor claimed $200,000 in depreciation, like in the above example, and later sold the property for a profit, that $200,000 would be taxed at the higher recapture rate, reducing the net gain. Understanding these tax rules allows investors to plan strategically, potentially using tools like 1031 exchanges to defer taxes and reinvest in higher-performing assets, ultimately protecting and growing their wealth.
Strategies to Minimize Depreciation Recapture
Investors can actively minimize depreciation recapture taxes in multifamily real estate by leveraging several strategic approaches:
- 1031 Exchange: Defer taxes by reinvesting proceeds from a property sale into a like-kind property, allowing investors to preserve capital and continue growing their portfolio.
- Cost Segregation Study: Accelerate depreciation by identifying and reclassifying specific property components (e.g., appliances, fixtures) for faster write-offs, reducing taxable income in the early years.
- Long-Term Ownership: Lower depreciation recapture liability by holding properties longer, spreading out depreciation benefits, and capitalizing on long-term property appreciation.
By combining these strategies, investors can protect their returns, maximize tax advantages, and scale their multifamily portfolios more efficiently. (big quote marks)
Key Takeaways for Multifamily Investors
In multifamily syndications, depreciation recapture presents unique considerations for investors. Syndicators often structure deals to maximize tax efficiency by strategically allocating depreciation benefits across investors, helping to reduce taxable income during ownership. However, when the property is sold, investors may face depreciation recapture taxes on their share of the gains. Investors should consult a tax professional who understands syndication-specific strategies to navigate these complexities and minimize tax liabilities. This proactive approach ensures investors fully leverage tax advantages while protecting their returns.
Book a call to see how you can utilize these investment strategies this tax season.
FAQs About Depreciation Recapture
How Is Depreciation Recapture Taxed?
Depreciation recapture is taxed as ordinary income, typically at a rate of up to 25%, separate from capital gains tax.
Can Depreciation Recapture Be Avoided?
While it can’t always be avoided, strategies like 1031 exchanges, cost segregation, and careful planning can minimize its impact.
Does Depreciation Recapture Apply to Multi-Family Syndication?
Yes, it applies when properties are sold, and investors should account for it when calculating potential returns.
What Is a 1031 Exchange?
A tax-deferral strategy allows investors to reinvest sale proceeds into like-kind properties, delaying depreciation recapture and capital gains taxes.
