Many of your clients have a good handle on appreciation but are often clueless about depreciation. They either forget, or never really understood, that their annual income-tax deductions for depreciation come with a significant price: RECAPTURE.

Recapture is when your friend buys your lunch, and says “you can get it next time”, but repeatedly buys your lunch until you forget that you are supposed to buy your own lunch in the first place. Then one day he hosts a dinner party and gives you the entire bill. Although the amount of the dinner bill is less than the combined costs of all the lunches he paid for, in that moment all you can think about is the shock of paying a bill you did not expect to receive. Out of nowhere, your free lunches were just—BOOM!—recaptured.

Sadly, recapture tax is far more expensive than a dinner party.

Upon the sale of an investment property, depreciation-recapture taxes can potentially be higher than long-term capital gains taxes. After allowing investors to claim depreciation over years for a property whose value may not have been decreasing, the IRS wants its money back. The tax bill is perhaps not quite what one otherwise may have paid in income taxes, but it can be significant.

Each year that your clients claim depreciation to reduce their otherwise taxable income, they also reduce the “cost basis” of their original investment purchase. Cost basis is an accounting metric that starts as a real number (purchase price) and can increase based on more real numbers (such as a new roof or pool), but ultimately becomes somewhat notional after being adjusted for multiple annual depreciation deductions.

After 27.5 years of depreciation deductions, the cost basis of a residential rental can be reduced to zero.  If sold without conducting a 1031 exchange, the property’s entire sales price may be taxable, with the entire original value being subjected to recapture tax—potentially at a higher tax rate than regular capital-gains tax.

Do not let your clients think they will pay no capital-gains tax, simply because their property has not appreciated.   Depreciation may be lurking in the shadows, waiting to be recaptured.

The contents herein constitute neither an offer to sell nor a solicitation of an offer to buy any security, which can only be made by prospectus.  Investors should understand all fees associated with a particular investment and how those fees could affect the overall performance of the investment. Neither 1031 Capital Solutions or its representatives, nor DFPG Investments, LLC provide tax or legal advice, as such advice can only be provided by a qualified tax or legal professional, who all investors should consult prior to making any investment decision.