Tax Smart Real Estate Investors Podcast - Episode 193 Summary

Title: When is the Depreciation Recapture Tax Due When Selling a Property Using an Installment Sale?
Host: Hall CPA
Release Date: September 27, 2022

Introduction to Depreciation Recapture in Installment Sales

In Episode 193 of the Tax Smart Real Estate Investors Podcast, hosted by Hall CPA, the discussion centers around the intricacies of depreciation recapture tax when selling real estate through an installment sale. Brandon Hall delves into whether depreciation recapture must be paid upfront or can be spread out over the installment period, providing valuable insights for real estate investors navigating complex tax scenarios.

Understanding Depreciation Recapture

Depreciation recapture occurs when the depreciation deductions taken on a property are subject to taxation upon its sale. Brandon categorizes depreciation recapture into three distinct types:

1. Section 1245 Gain
2. Section 1250 Gain
3. Unrecaptured Section 1250 Gain

1. Section 1245 Gain

• Definition: Pertains to bonus or accelerated depreciation taken on personal property with a 5 or 7-year life.
• Taxation: Recaptured at ordinary tax rates, which can be as high as 37%.
• Example: Personal property like appliances, carpets, or cabinetry falls under this category.

Notable Quote:
"Section 1245 gain, that's any bonus depreciation or any accelerated depreciation that I've taken on my five and seven-year property, that's section 1245 gain. That's going to be recaptured on my ordinary tax rates as high as 37%."
[Timestamp: 02:30]

2. Section 1250 Gain

• Definition: Involves excess depreciation over the straight-line method on real property with a useful life exceeding 20 years.
• Taxation: Also recaptured at ordinary tax rates, up to 37%.
• Example: Improvements like parking lots with a 15-year life where bonus depreciation is applied.

Notable Quote:
"Section 1250 gain is accelerated depreciation in excess of straight line depreciation. So it's a little bit different than section 1245 gain."
[Timestamp: 04:15]

3. Unrecaptured Section 1250 Gain

• Definition: The portion of depreciation on real property depreciated over 27.5 or 39 years (residential or commercial).
• Taxation: Capped at a maximum of 25%.
• Example: Structural components like roofs or HVAC systems.

Notable Quote:
"Unrecaptured section 1250 gain, that is the depreciation that I have taken on the building and in any other type of like 27 and a half year component. That's all going to be unrecaptured section 1250 gain."
[Timestamp: 07:45]

Installment Sales and Depreciation Recapture

Brandon explains how selling property through an installment sale affects depreciation recapture taxation:

• Outright Sale: All depreciation recapture (Sections 1245 and 1250) is taxed in the year of sale.
• Installment Sale: Allows spreading out the recognition of certain gains over the installment period.

Key Points:

1. Recognition of Gains:

   • Section 1245 & 1250 Gain: Must be recognized and taxed at ordinary rates in the year of sale, even in an installment arrangement.
   • Unrecaptured Section 1250 Gain: Can be spread over the installment period and taxed at up to 25%.

2. Principal and Interest:

   • Principal Return: Represents the recovery of the property's cost basis and is not taxable.
   • Interest: Part of the installment payments is considered interest income and is taxable.

Notable Quote:
"With five-year and seven-year property, I recapture it at my ordinary tax rates, maximum 37%. With my 15-year property, any excess over straight line, I recapture my ordinary tax rates, maximum 37%. Anything else is a 25% maximum."
[Timestamp: 10:05]

Practical Example

Brandon walks through a hypothetical scenario to illustrate the application of these principles:

• Property Gains:

  • Section 1245 & 1250 Gain: $50,000
  • Unrecaptured Section 1250 Gain: $100,000
  • Capital Gain (Appreciation): $100,000

• Installment Sale Details:

  • Term: 20 years
  • Annual Payment: $20,000 (including $10,000 gain)

• Tax Implications:

  • Year of Sale:
    • Recognize the entire $50,000 Section 1245 & 1250 gain at ordinary tax rates.
  • Over 10 Years:
    • Spread the $100,000 Unrecaptured Section 1250 Gain across $10,000 per year, taxed at up to 25%.
  • After 10 Years:
    • Recognize and tax the remaining $100,000 Capital Gain from property appreciation.

Notable Quote:
"Starting in year 11, the $10,000 of gain associated with every year's $20,000 of payments will then be my section 1231 gain, the gain from appreciation."
[Timestamp: 09:35]

Summary and Conclusions

Brandon summarizes the three types of depreciation recapture and their tax treatments in the context of installment sales:

• Section 1245 & 1250 Gains: Taxed at ordinary rates in the year of sale.
• Unrecaptured Section 1250 Gain: Taxed at a maximum of 25% and can be recognized over the installment period.
• Capital Gain from Appreciation: Recognized after fully recapturing depreciation gains.

This structured approach allows real estate investors to manage their tax liabilities more effectively over time, leveraging installment sales to mitigate immediate tax burdens associated with depreciation recapture.

Notable Quote:
"In summary, there's three types of depreciation recapture. There's section 1245 gain, there's section 1250 gain, and there's unrecaptured section 1250 gain. The first two section 1245 and 1250 gain I recapture at my ordinary tax rates. And I have to pay those upfront in the year of sale when I have an installment sale. That third bucket unrecaptured section 1250 gain that's taxed at a maximum 25% rate and that can be spread out with my installment payments over time."
[Timestamp: 11:50]

This episode provides a comprehensive breakdown of depreciation recapture in installment sales, equipping real estate investors with the knowledge to optimize their tax strategies and enhance their investment outcomes.

For more detailed discussions and expert insights, visit TheRealEstateCPA.com/Podcast or explore additional resources at TaxSmartInvestors.com/Insiders.