193. When is the Depreciation Recapture Tax Due When Selling a Property Using an Installment Sale?

Summary

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

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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]

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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.

Transcript

[A]

You're now listening to the Real Estate.

[B]

CPA Podcast, your source for all things real estate accounting and tax. Here we reveal our secrets that can save you thousands in taxes, streamline your accounting process, and help grow your business. Stay tuned to hear insightful interviews with industry experts, successful real estate investors, and current clients on what strategies they use to grow their business and how they steer clear of Uncle Sam.

[A]

Hey, thanks for tuning into this episode of the TaxSmart REI podcast. In this episode we take a clip from our YouTube channel where Brandon hall discusses installment sales, specifically whether or not you have to pay the depreciation recapture tax up front or you get to spread it over the course of the installment sale. If you haven't already subscribed to our YouTube channel, you can do so by going to YouTube and searching for Tax Smart Investors and hitting that subscribe and that Bell icon so you don't miss out on future releases. The link is also in the Show Notes. We'll see you there, but for right now, we're gonna jump right into today's episode after a quick word from Landlord Studio. Having a good rental management software is essential for landlords who wanna stay on top of their finances, save time and reduce stress during tax time. Without one, you're reliant on outdated and error prone processes like spreadsheets, paper receipts and manual reconciliation. Who wants to do that? This can lead to compliance issues, overpaid taxes, expensive vacancy periods, or worse. Esther your income and expense tracking with Landlord Studio today import transactions to quickly reconcile expenses, automate rent collection and income tracking. Digitize receipts on the go and instantly generate financial reports including Schedule E to make tax filing a breeze. Landlord Studio is much more than just a rental accounting solution though. Take advantage of their range of property management tools from finding and screening tenants to managing leases and even tracking and managing property maintenance tasks. You can learn more about Landlord Studio and start your 14 day free trial at landlordstudio.com CPA. Use the coupon code realestatecpa at checkout for 25% off your plan. Again, that's landlordstudio.com CPA and use coupon code realestatecpa to get 25% off your plan and a 14 day free trial today.

[B]

Today's topic is all about installment sales and what depreciation we recapture whenever we sell real estate on an installment sale. Now, whenever you hear the term depreciation recapture, there's actually three types of depreciation recapture. There's something called section 1245 gain. There's 1250 gain. And then there's unrecaptured 1250 gain, section 1245 and section 1250 gain, those are the first two types of depreciation recapture that is recaptured at ordinary tax rates. Now section 1245, 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 high as 37%. My section 1250 gain is accelerated depreciation in excess of straight line depreciation. So it's a little bit different than section 1245 gain. Now the section 1240, the section 1250 gain in excess of straight line, an example of that would be, let's say that I put in a parking lot that cost me $15,000. Well, if a parking lot costs $15,000 and it has a useful life of 15 years, it's Section 1250 property. But I can bonus depreciate that $15,000 because 15 years is less than 20 years. And per our bonus depreciation rules, we can 100% expense via bonus depreciation any component with a useful life of less than 20 years. So we take this parking lot, we spend $15,000 on it. I immediately write off $15,000 on my tax returns. After three years, I sell the building and I sell the parking lot included. Three years over a straight line method for a $15,000 property or parking lot that would have lasted 15 years. Three years of that is $3,000. Just you take the asset cost, you divide it by the useful life, that's straight line. So after three years of ownership, I sell this parking lot. I should have taken $3,000, but I actually took $15,000. So my excess depreciation over straight line in this example is $15,000 of accelerated bonus depreciation minus the $3,000 of straight line depreciation. So my excess is $12,000. That's going to be my section 1250 gain. That's bucket number two of depreciation recapture. And that is also taxed at ordinary tax rate. So bucket number one was my section 1245 gain, ordinary tax rates. Bucket number two is section 1250 gain. That's any excess over straight line that's also taxed at ordinary tax rates. My third bucket is my unrecaptured 12.50 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. So any Sort of structural or you know, H vac roof, anything like that. That's all going to be unrecaptured. Section 1250 gain. I'm depreciating those, those components over 27 and a half years. It's straight line. And I do recapture that depreciation, but it's a maximum 25% rate. So full circle, let's get back to the installment sale. I sell my real estate on installment, how am I taxed? Or how does that depreciation recapture factor in? If we didn't sell on installment, if we just sold it straight up, we would pay recapture tax on all of our 1245 property, all the depreciation that we've claimed on our section 1245 property. And again, what is section 1245 property? It's my five year and my seven year property, my personal properties, my fridges, my applaud, my carpet, my cabinets, anything like that, my Section 1250 property. I'm going to pay ordinary tax rates on that if it's 15 year property and if I accelerated depreciation and then I'm also going to pay recapture tax on the building depreciation that I've taken over the useful life. So you got to look at your tax returns and you look at all that depreciation that you've taken, you're going to recapture that when you sell that property. You're going to recapture all of that when you sell that property. Every single, every single dollar of depreciation you've taken, you will recapture when you sell that property. And then again, you just have to figure out what is the tax rate that's going to be applied to all that recapture based on, you know, whether it's section 1245 or section 1250 and what type of section 1250 property it ultimately is. But just to simplify it, I look at that balance sheet, I look at all the depreciation that I've claimed, I'm going to recapture all of that. But 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. And that's my unrecaptured 1250 gain. But when I sell an installment, it's a little bit different. Now what is installment? That means that I sell you my property, but, but instead of selling the entire thing and just cashing fully out, I'm gonna sell it to you, but I'm gonna Carry back a note. And the note just ranges depending on whatever our deal is. So I'm gonna play bank, right? So you're gonna pay me every single month, just like you'd pay a bank that's selling on installment. But for me, every single month I've got to recognize principal, right? So I'm gonna get some of my basis back. Cause I've gotta take my the basis of the property, the cost basis of the property I've got, spread it out over all the payments that I receive, the upfront down payment plus all the monthly payments. So I'm going to have some cost basis that comes back to me. It's not taxable because it's my cost basis. I'm going to have some gain and then I'm going to have some interest. So that's going to be part of every single payment that I receive on installment over the lifetime of the note. Additionally, I just told you that each one of those monthly payments that I'm going to receive by seller financing a property, basically installment sale, each one of those monthly payments that I'm going to receive is going to include cost, basis, principal, it's going to include gain and it's going to include interest. But here's the rub. With my unrecaptured section 1250 gain, that's all the depreciation again that I've claimed on my 27 and a half year or 39 year components. I have to recapture that fully first. So every monthly payment that I receive, the gain associated with that monthly payment will be my unrecaptured 1250 gain before it's ever going to be the gain from appreciation, section 1231 gain. So what does this mean? Well, let's walk through an example. So I sell a Property, I have $50,000 of section 1245 and section 1250 gain. I have $100,000 of unrecaptured section 1250 gain. And I have $100,000 of actual capital gain. And I'm going to engage the buyer in a seller finance transaction, meaning I'm selling my property to the buyer on installment and the buyer is going to make a payment to me every month. And let's just say the Note term is 20 years. So I have $100,000 of gain from appreciation. That's my 1231 gain. I have $100,000 of Gain from depreciation. That's my, that's my unrecaptured section 1250 gain. And then I also have $50,000 of gain coming from my section 1245 property and my section 1250 property where I've taken depreciation in excess of Straight Line. I'm just making these numbers up. So the first year that I sell this property, in the year that I sell the property, I've got to recognize that full $50,000 of gain associated with my section 1245 property and my section 1250 property, accelerated depreciation in excess of Straight Line. So I'm going to pay my ordinary tax rate on that first $50,000 of gain. The next $100,000 related to depreciation was from my unrecaptured section 1250 gain. On that, I'm going to spread out recognition of that gain through all the payments that I receive. Now let's assume every year I receive $20,000 worth of payments. But $10,000 worth of that payments every single year is the gain portion of those payments. So I receive $20,000 of payments a year, but $10,000 of that is attributed to the gain. Because I have $100,000 of unrecaptured section 1250 gain, I'm going to first recognize all $100,000 of that unrecaptured section 1250 Gain each year with those $10,000 of gain built into those payments. So it's going to take me 10 years to recognize the unrecaptured section 1250 gain that was associated with this sale. 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. So it's really important to understand in this instance that for the first 10 years, the gain portion from my installment payments is going to be taxed at a maximum rate of 25%. I'm not going to get to spread my long term capital gains out because I first have to fully recognize the unrecaptured section 1250 gain, the gain coming from the depreciation that I've claimed on on my buildings, my 27 and a half year, 39 year property. I recognize all of that first before I recognize and pay taxes on the long term capital gain, the gain from appreciation. So 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. But I have to recognize that gain to the fullest before I'm able to start recognizing gain from the actual appreciation of the asset.

[A]

Hope you enjoyed this clip and if you want more TaxSmart YouTube videos, go over to YouTube and search for Tax Smart Investors and hit that subscribe button and bell icon so you don't miss out on future releases. That's all for today and we'll catch you on the next episode of TaxSmart.

[B]

Rei, thanks for listening to today's show. If you enjoyed the show, please find us on itunes and leave us a review. You can also email us at Contact with any feedback or topic suggestions. We are always taking on new clients and and with the new tax laws in play, you really don't want to navigate this alone. Let us help you save money on taxes with your accounting and CFO needs to become a client. Navigate to our client [e-mail] and fill out a web form with as much detail about your situation as possible. Thanks so much for listening. Have a great rest of your week.