As we mentioned in our previous blog post, "Lower Your Taxes and Increase Your Cash Flow," many owners of commercial real estate are not fully utilizing the possible tax deductions available via depreciation.
Before discussing what happens when you sell a commercial property, it is important to understand what happens while you own the commercial property. The same applies to owners of residential rental properties as well.
What is depreciation? What is the tax benefit of depreciation?
Owners of commercial real estate can reduce their tax bill by depreciating the value of their property over a set period of time (the buildings' "useful life," as defined by the IRS): the IRS depreciates residential rental buildings over 27.5 years and retail and other commercial structures over 39 years. This means that every year you own a commercial or residential rental property you deduct the depreciation from your income tax.
What happens when I sell a commercial property?
When you sell your property, your tax bill will depend on two basic pieces of information, your adjusted cost basis and selling price. Your adjusted cost basis will include the original cost of the property, plus various costs, such as capital improvements (i.e., upgrades), less the amount by which the property was depreciated. The difference between your adjusted cost basis and your selling price is your profit (or loss).
When your adjusted cost basis is reduced through depreciation, you incur a future tax liability. When you sell the property for more than the adjusted cost basis, you will be taxed at two different rates, depending on your annual income and on the amount of profit you receive from the sale. Profits are taxed both two different rates: "depreciation recapture" (25%) and capital gains (either 15 or 20%, depending on your annual income). Depreciation recapture occurs because you benefited from depreciation deductions that offset your ordinary income over the course of your ownership; therefore, upon a sale, the government taxes that profit at a rate that is higher than the capital gains rate. The amount of profit subject to depreciation recapture is limited to the sum of depreciation deductions you took. Any profit above the depreciated amount is taxed at the more-favorable capital gains rate.
"It is important to account for depreciation recapture when deciding if you want to sell income-generating real estate," said Jack Rose, Chief Strategist at Breakwater Equity Partners. "Otherwise, your tax bill will be much higher than you anticipated." Many savvy commercial real estate owners seek out advisory firms to calculate and verify the accumulated depreciation on their commercial asset before deposing of the property. Planning ahead, and weighing all of the consequences can help you maximize the return from your property sale.