Depreciation Recapture Income Tax Rates and Guidelines
You are probably already familiar with the current Federal capital gain income tax rates, which vary based on your income tax bracket, for properties held more than 12 months. In most cases, you will find yourself subject to the maximum Federal capital gain income tax rate of 15%.
However, you may not know that depreciation recapture is taxed for Federal income tax purposes at substantially higher rates. You may be subject to state or local income taxes as well, so you must always consult with your tax advisor for more specific and complete information.
Non-residential real estate is considered to be 39 year depreciable property pursuant to Section 1250 of the Internal Revenue Code that has been depreciated using the straight-line method of depreciation since 1986. When 1250 property that has been in service for more than one (1) year is disposed of (sold), there are three (3) possible applicable income tax rates, which are discussed below.
Excess Depreciation Recapture
Ordinary income rates (up to 35%) apply for excess depreciation recaptured. Excess depreciation is that portion of depreciation that exceeds straight-line depreciation. In many cases, since 1250 property has been required to be depreciated in accordance with straight-line depreciation since 1986, there will be no excess depreciation over straight-line depreciation. However, even during the post-1986 time period, certain structures and improvements to property, such as sidewalks, driveways, fencing, parking, and landscaping, have been depreciable over 15 years, using 150% declining balance method. This treatment will cause excess depreciation recapture on the disposition of 1250 property on these improvements.
Section 1250 depreciation, which is deducted over 39 years using the straight-line method, will generate accumulated depreciation over the years. This accumulated 1250 depreciation is taxed at a flat rate of 25% upon disposition (sale), up to a maximum of the amount of the recognized gain.
The new standard federal income tax rate on capital gains for Code Section 1250 property held longer than one year is now fifteen percent (15%). This 15% rate applies to taxable gain, after first applying the ordinary income recapture rate on excess depreciation, and then the regular Section 1250 depreciation gain at 25%. Any untaxed gain left is then taxed at the 15% capital gains rate.
Depreciation Recapture in a 1031 Exchange
The foregoing income tax rates apply to boot received in a 1031 exchange transaction to the extent that there is gain to be recognized. The order of taxation of boot runs consecutive from items one to three (i.e. taxable gain from the transaction starts with excess recapture, then the 25% rate is applied to 1250 depreciation, and finally the 15% capital gains rate is applied to any taxable boot that is left).