377. You Can't Escape Depreciation Recapture (But Here's How to Defer It)

Summary

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Tax Smart Real Estate Investors Podcast – Episode 377

Title: You Can't Escape Depreciation Recapture (But Here's How to Defer It)
Host: Tom Wheelwright, Nate (Hall CPA)
Date: May 12, 2026
Theme: Understanding Depreciation Recapture Tax—How it works, why you can’t escape it, and strategic ways to defer or mitigate it as a real estate investor.

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Episode Overview

This episode dives deep into the often-misunderstood topic of depreciation recapture tax for real estate investors. Tom Wheelwright and Nate break down the technical tax code, outline exactly how recapture works when selling investment properties (especially with short-term rentals), and lay out practical strategies to mitigate or defer the tax hit. Their goal: Demystify these complicated buckets for investors, saving them serious money and headaches come tax time.

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Key Discussion Points & Insights

1. What is Depreciation Recapture?

[00:40] Tom:

• When you sell an investment or rental property, you don’t just pay capital gains tax; you also pay depreciation recapture tax.
• Recapture is based on the depreciation deductions you’ve previously taken (or were eligible to take).

“There’s actually three different buckets and three different rates and a sequence on housing tax that causes much confusion for investors and tax professionals alike.” – Tom [00:56]

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2. The Three Buckets of Depreciation Recapture

a. 1245 Property – Ordinary Income Rate (up to 37%)

[03:36] Tom & Nate:

• Applies to components depreciated over 5, 7, or 15 years (appliances, carpeting, land improvements like pools/fences—usually bonus depreciated via cost segregation).
• All gain tied to this property, up to the depreciation amount, is taxed at top marginal ordinary rates.

b. 1250 Property – Max 25% (Unrecaptured)

[07:07] Nate & Tom:

• Applies to straight-line depreciation on the building structure (27.5 years for residential, 39 for commercial).
• Taxed at a capped 25% rate.

“That’s just the straight line depreciation you take on the building itself... taxed at the max rate of 25%. That’s pretty much what you need to know.” – Tom [08:29]

c. 1231 Gain – Capital Gains Rate (15-20% or more)

• The “spillover” after recapture buckets are filled—applies to any remaining gain, taxed at favorable capital gains rates.

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3. Should You Still Take Bonus Depreciation If You Have to Recapture It?

[09:59] Nate:

• Yes, because of the time value of money: You can reinvest today’s tax savings for potentially much larger returns before you eventually pay recapture.
• The IRS will “impute” depreciation recapture even if you didn’t claim it.

“If you do not do it, the IRS will impute the depreciation that you should have taken. So you have to take it.” – Tom [09:31]

Example:

• Saving $100k in taxes and investing at 8% annually could grow to over $215k in 10 years ([11:02] Tom).

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4. How to Mitigate and Strategically Allocate Depreciation Recapture

[15:12] Tom & Nate:

• Proper allocation of sales price to different asset classes (furniture, land, improvements) during sale is a key, underutilized tool.
• “Reverse cost seg” (reverse 1245 study): Allocate less value to recapture-prone assets; more to land/building (which gets capital gains treatment).

“That’s the whole game... allocate more value to the 1231, the land and the actual structure... reduce your depreciation recapture.” – Nate [16:09]

Real World Tactics:

• For furnished STRs, document values for furnishings and other short-life components to help with allocation at sale.
• On commercial properties: Remove worthless tenant improvements (“partial asset disposition”) to limit recapture.

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5. Key Exit Strategies to Defer Recapture

a. 1031 Exchange (“Golden Handcuffs”)

[19:00] Nate & Tom:

• Can fully defer capital gains and both 1245/1250 recapture if you “trade up” into another real estate investment—but must do a cost segregation study on the new (replacement) property to keep buckets matched.
• This is deferral, not elimination: taxes kick in if you ever sell without a 1031.

b. Step-Up In Basis at Death (“Buy, Borrow, Die”)

[20:26] Tom:

• If you hold until death, heirs receive a full step-up to fair market value, eliminating all depreciation recapture and capital gain liability.
• Only about 10% of 1031s go this route in practice ([21:15] Nate).

c. Installment Sale

[22:23] Nate:

• Can spread capital gains across multiple years but must recognize recapture in full the year of sale.

d. Section 121 Exclusion (Sale of Former Primary Residence)

[23:33] Nate & Tom:

• Homeowners can generally exclude a portion of gain after converting a rental back to personal residence, but must still recapture depreciation taken during rental period.

“You can never avoid depreciation recapture. It always sticks to the property.” – Nate [24:51]

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6. FAQs & Common Misconceptions

[26:00–28:00] Tom & Nate

• Q: If I never claimed depreciation, do I avoid recapture?
  A: No, IRS will still recapture as if you’d claimed it.
• Q: Can I avoid recapture by converting to primary residence?
  A: Only partially, via Section 121. Depreciation stickiness remains.
• Q: Do I recapture all depreciation if I only owned 50%?
  A: Only your allocated share (typically 50%).

“An ounce of prevention is worth a pound of cure. Always try to make sure you’re doing things right the first time.” – Tom [27:42]

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Notable Quotes & Memorable Moments

• “You’re going to have another tax called the depreciation recapture tax that’s going to be from the depreciation that you’ve taken over the time you own the property.”
  — Tom [00:40]

• “You got an ordinary deduction. Now... the IRS basically says great, ordinary deduction, now you get ordinary income.”
  — Nate [04:35]

• “Basically like, hey, if you’re telling me that I can get $30,000, $50,000 from the government tax free and then I just have to pay it back in five years, I think I’m going to take that 100 times out of 10.”
  — Nate [10:50]

• “Depreciation recapture always sticks with the property... you can never avoid it. Even if you transfer it to your kiddos early.”
  — Nate [24:51]

• “The only real way to escape it is by the step-up at death.”
  — Nate [26:46]

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Important Timestamps & Segments

• 00:40–03:36: Definition and Mechanism of Depreciation Recapture
• 04:35–08:45: Depreciation “Buckets”—1245, 1250, 1231
• 09:59–12:00: Strategic Value & Time Value of Depreciation
• 15:12–17:46: Allocating Sale Price to Minimize Recapture
• 19:00–22:22: Strategies to Defer/Eliminate Recapture (1031, Step-Up, Installment Sale)
• 22:23–25:00: Section 121 Exclusion Limitations
• 26:00–28:00: FAQ Round-Up

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Tone & Language

• Conversational, practical, and sometimes humorous—clear bias toward investor empowerment through smart tax strategy.
• Emphasis on proactive (not reactive) planning and engaging a qualified advisor.

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Takeaways for Listeners

• Depreciation recapture is complex, unavoidable, but manageable and deferrable with the right planning.
• Always consult with a real estate tax advisor before you purchase or sell; strategic choices up front can save tens or hundreds of thousands.
• Understand your “buckets” and use allocation and exit strategies wisely.
• Submit FAQs for future episodes!

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For more episodes and tax-saving resources:
Visit www.TheRealEstateCPA.com/Podcast

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Transcript

[Tom Wheelwright]

You're now listening to the Tax Smart REI Podcast, the number one tax podcast for real estate investors,

[Podcast Host/Producer]

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.

[Tom]

Thank you for tuning into this week's episode of the Taxpayer Podcast.

[Tom Wheelwright]

In today's episode, we're going to be talking about how depreciation recapture is actually taxed.

[Tom]

So believe it or not, when you sell a property that you've held for investment or you held for rent, you're not just going to have capital gains taxes. You're actually going to have another tax called the depreciation recapture tax that's going to be from the depreciation that you've taken over the time you own the property.

[Tom Wheelwright]

The thing is, there's actually three different

[Tom]

buckets and three different rates and a sequence on housing tax that causes much confusion for investors and tax professionals alike. We're going to distill that all down, make it super clear by the end of this episode exactly how depreciation recapture works and most importantly, how you can mitigate your exposure. We'll be diving into all of that in just one minute.

[Tom Wheelwright]

If you own short term rentals or

[Tom]

you're thinking about investing in them, this is worth paying attention to.

[Tom Wheelwright]

A lot of investors miss out on tax savings simply because they don't fully understand how the short term rental tax rules work. They that's exactly why we put together our Short Term Rental Tax Strategy bundle. It includes a short term rental tax strategy white paper that explains the rules in a clear, practical way. We also included a material participation guide to help you better understand how to qualify for the tax treatment many investors are aiming for. It's designed specifically for short term rental owners with straightforward guidance on how you

[Tom]

can actually use it.

[Tom Wheelwright]

If you want to get a better handle on how this strategy works and whether it applies to you, check it out. Go to www.therealcpa.com str tax bundle to get the short Term Rental tax bundle today. You could also check it out using the link in the show notes this episode. That's all for now. We'll be diving right back into today's episode.

[Tom]

All right, and we're back.

[Tom Wheelwright]

So depreciation recapture, the age old tax

[Tom]

that some people aren't even aware that they're Going to have to pay. Nate, do we want to start maybe just diving into a little bit more about what depreciation recapture tax is and

[Nate]

why it matters 100%? Tom, let's dive in. I think it's one of the most important things that people a forget about, right? Totally 100% agree with this. They forget about. They're also incredibly curious on, right? So I actually don't think we talk about this topic enough. But let's just run through a scenario, right? Let's just find someone in the wild and like we'll use this scenario and just kind of go through what they would have done. So let's say someone decides to go after the short term rental strategy, maybe real estate professional, and they do 100 hours material participation. They do everything, right? Everything that we've recommended and told them to do. They material participate, keep it logged. They get a cost irrigation study from our cost side guy, Edward. They do all of that and then in three years from now they go, man, this property is really appreciated. I think I want to sell it now because I'm going to get a massive return on equity for doing this, right? I go, okay, awesome. You took $400,000 bonus depreciation, now you're selling. What happens now? And so there's actually a lot that goes into that. So there's multiple kinds of depreciation recapture, right? This is where it gets kind of confusing and we got to use some tax terms. Sorry, everybody. Basically the first one is 1245 and 1250 depreciation recapture. And that specifically comes from any items that you took bonus depreciation on, right, Tom? Now what are some of those items, Tom, that someone might have taken bonus depreciation on?

[Tom]

Yeah, that's a great question. So usually it's going to be 5, 7 or 15 year property. Let's break down a little bit about what each one of those actually mean. So five year property is property that it's called tangible, personal property. When it comes to rentals, we're talking about things like appliances, certain types of fixtures, carpeting, things that are not permanently affixed to the ground. That is five year property. Another type of property, the seven year property is kind of like a catch all bucket when something just doesn't fit into one of the other categories. So that does occur, but we don't see that all too often. So that's just another component of it. But then the 15 year property that is typically going to be the land improvements, the things like the sheds, the decks, the fences, landscaping, the pools, those Types of things are land improvements and that is 15 year property. So you can bonus depreciate property that has a class life or depreciable life of 20 years or less. And again in real estate, that's that five, seven and 15 year property. That is what is eligible for bonus depreciation.

[Nate]

Yep, totally Tom. And so anything that was involved in that, right? Guess what, you got ordinary deduction. You got to take that, you're able to take an ordinary deduction, write that completely off. And now the IRS and the tax code basically says great, ordinary deduction. And now you get ordinary income. So I think we should take two steps back actually and basically kind of look at this. So the way this kind of works actually is whenever you sell a business investment type property, it's taxed actually at capital gains rates. Why? That's called 1231 property, right. What's 1231 property? Basically just says you were using this in a trader business or so for basically to make money. Right? That's basically what it comes down to. So when you sell it, they go, the government goes, hey, no problem, you're going to be taxed only at 20% on that unless you do the cost cycle you just mentioned. You carve out all those items and now you're going to get taxed at ordinary income. So let's just say it's a $500,000 gain. You took 400k of bonus depreciation, that $400,000 of the 500k of gain, right? Think of it. I like think of it as buckets, Tom. Like I really like think about this as like buckets. Is that like there's a certain bucket but there's a filler. The only one that doesn't fill is a 1231 bucket. So the 1245 bucket fills up until you've gotten to the number of gain, right? Let's just say it's $400,000. Like we've been saying, once you get to that number, the rest of the gain spills out of that bucket into the next bucket. And so that means all of that $400,000 is taxed at the top ordinary tax bracket. That. So just FYI there, however, there's ways we can defer that. There's exit strategy games we can play. So it doesn't mean you're going to be hit with that, but you got to take that into your tax planning consideration, right? Tomorrow.

[Tom]

Yeah, yeah, absolutely. So basically when you take the bonus depreciation or accelerated depreciation, and that includes also like Double declining balance. We're not going too far in depth into that today, but most, most of us will be taking bonus depreciation. You are taxed up to 37% when you do recapture that. But the reason why you'd still want to do that is usually the time value money. A dollar saved today is worth more than a dollar tomorrow because you could take the money you saved and go ahead and reinvest it, earn a return on your investment. And in some cases there might even be tax rate arbitrage. Maybe this year you're in a very high tax bracket, you're in the top bracket. But maybe when you go to sell that property, you might not be. That's just something else to be cognizant of. But we'll talk more about later on how to mitigate that. But that's just something to be aware of. And yeah, that is the depreciation recapture on 1245 property, which is property that use accelerated depreciation on. Now, right, next we got bucket two, right? The second bucket on recaptured 1250 gain which is taxed at a max rate of 25%.

[Nate]

Right. So this is what would have happened if you'd never done a cost segregation study. Basically, if you've never done a cost segregation study, you still would have gotten hit with unrecaptured 12:15. What does this mean? Basically you're just getting taxed on depreciation that is in like the long technical version for it, but basically in excess of straight line depreciation. So that's why we'd fall into that first bucket. A lot of times if we do bonus depreciation, we. But if it doesn't fall into that bucket, then that means now whatever our straight line is, right, normally on our 27 and a half and 39 year property, on those items you are basically just going to get taxed at unrecaptured 1250 max 25%. So again, if you take that $500,000 of gain, you'll probably wind up, let's just say with $100,000 of straight line depreciation, right? That is the long term appreciation. Any of that $100,000 that's taxed at that 25% bucket, right Tom? So and that's totally deferable just FYI on that type of stuff, like if we get into the exit strategies that are involved with it, but it falls into that 1231 gain bucket. Right? So again, so you have our 1245 bucket. Just to clarify, the 1245 bucket, once we fill that one up, then we fall in the 1250 bucket and then once we fill that one up, then we fall into the 1231 bucket, which we'll talk about in a second. But Tom, anything to add on, like, what's unrecaptured 1250? I know it's like such a long term, I hate it to like, say like describe it to a client.

[Tom]

But it's just the straight line depreciation you take on the building itself over 27 and a half years for residential or 39 years for commercial. That depreciation you take, that is what's taxed at the max rate of 25%. That's just pretty much what you need to know there.

[Nate]

Yep, that's pretty much it. Right. Just FYI and like, Tom, I just, I want to go back. So like on buckets one and two, we, a lot of times we'll get from people, other CPAs, from other investors even saying, well, what's the point of taking this depreciation if I have to pay tax on it down the road? Is there even a point to it? Why should I even do it?

[Tom]

Yeah, well, first of all, you have to take depreciation of some sort for an investment or rental property. It's not really something that you have an option to do or not. You have the option to cost Sega or not. Right. And take bonus depreciation that you have the option of, but you don't have the option to depreciate an asset or not. In fact, if you do not do it, the IRS will impute the depreciation that you should have taken. So not only have you not taken the depreciation that you should have been taking, so that's costing you potential tax aids, but also you're being charged on the depreciation recapture as if you took it anyway.

[Tom Wheelwright]

So you have to take it.

[Tom]

There's no way out of that. It's just strategically doesn't make sense for you to accelerate that depreciation using a cost seg and bonus depreciation. That's usually the question. And if you're an active investor doing short term rentals or you have reps, the answer to that question is usually yes or typically yes. But there could be other strategic reasons to do that. Anyway, so something you want to speak to your tax advisor about of whether or not you should be doing this if you're not already. But that's pretty much what I think people need to know for those two buckets.

[Nate]

Totally, Tom. So the conversation is, then why should I do A cost segregation study, Right. Like should I advance and take all this depreciation if I'm going to get taxed on it down the road anyways? Right. It's like feels pointless. And we are of the opinion, I'm personally of the opinion, Tom's personally of the opinion that it still makes sense because of time value of money. If you do a cost segregation today and you know you're going to sell your property in five years or three years or even like four. Right. Somewhere in that three to five year range is my personal recommendation. If you're going to do that, then it makes sense because you're going to get capital, right? You're going to get capital in the way of framing of taxes. Right. And you've reduced your cost of taxes in a transaction for momentarily and that means you have more capital to invest in the market, purchase another real estate property, basically invest today so that you've now got to take advantage of the appreciation for five more years. Sure. You sell the money back. You basically got a tax free loan from the government. That's honestly the best way to say that. It's like basically like, hey, if you're telling me that I can get 30, $50,000 from the government tax free and then I just have to pay it back in five years, I think I'm going to take that 100 times out of 10, right Tom?

[Tom]

Yeah, yeah. No, 100%. And I always like to use this example. If you could save just to keep numbers clean, you could remove a zero from all this if you wanted to, or you can add a zero if you wanted to. If you were to save $100,000 in taxes as a result of using cost segregation and bonus depreciation, and you were to reinvest that a hundred thousand dollars at an 8% compounded rate for 10 years, you would have a total of $215,000 and change. So it's $115,000 that you did not have before. And that's the demonstration, the time value money of why you'd want to take it today. Now mind you, 8% is low for real estate. Typically if you're doing things right, you're usually targeting a double digit return on real estate. So those numbers could be much higher than that. When all said and done, if you reinvested into investments with a higher rate of return. But the point is the time value money allows you to reinvest that money and have that money produce money for you. When that money would have just been with the irs, right? Long Story short, that's one of the major reasons why you would do it.

[Nate]

And so again, it's just basically tax free capital and it makes sense from time value of money. And that's why we also don't recommend getting out of bonus appreciation elections. Right? Taking elections to not take bonus appreciation because even we don't take it that year, we can always go back and do a retroactive cost, pull it into a current year. Right? So just FYI on that piece, that's why I find it to be super, super valuable. So that is our overall philosophy on cost bonus appreciation. Are you a real estate investor, business owner, high earner, who feels like you're paying way too much in taxes? The problem usually isn't you. Most accountants are generalists. They don't really understand real estate, complicated income situations or don't work with you on strategies that lower your tax bill. We do. We work with real estate investors across the board. Long term rentals, short term rentals, multifamily commercial syndications, you name it. We'll help you get every deduction you're entitled to and help you grow your portfolio without the tax drag. For you business owners, we help you stop overpaying the IRS you and start building real wealth with the money you earn. The highest cost you'll ever deal with is taxes. If you're a high earner, we go way past the basic W2 stuff. There are legal ways to bring down your tax bill and most people have never heard of them. We also work with syndicators, developers and agents on complex deals most CPAs just aren't handling. This isn't just you're filing your return once a year. It's a real tax strategy built around what you want to do in your life. If you're ready to work with people who actually get it. Let's have a conversation. Request a call in the link in the show notes. Now the next one we'll kind of go to is qualified improvement property. Right? And what bucket this one falls into. Right. And so like technically it's a mixture of both. Right. It kind of falls into the unrecaptured 25% bucket and also falls into the not 25% bucket and the ordinary income bucket. But basically this came out out of 2017 tax cuts and Jobs Act. If you're in a short term rental and you do some kind of like tennis court or you do some kind of like hot tub, that's going to be what we call quit qualified improvement property. And that qualified improvement property is eligible for bonus depreciation and 179. So you get to take that ordinary deduction, get, take an accelerated deduction. Take that accelerated deduction. Just FYI, that will at some point down the road be treated as ordinary recapture and you'll get taxed on it. Right. I think one common misconception I hear a lot tomorrow from folks is they say, hey, wait, so I have to pay back all the deductions I got. And that's not, that's not the way to think about that. The basically way to think about that is like, hey, if every dollar that you get as a deduction, you get 30% back on that on average. Right. That's the way I think about that. So that's what, that 30% is what you would technically have to pay back to the irs, not actually the deduction itself. Right. Tom, you probably heard that a lot too.

[Tom]

Yeah, you know, I certainly do get that a lot. But you know, as far as QIP goes, it applies to interior improvements to non residential buildings. So that could be office, retail, mistaken industrial properties, short term rentals because they're considered non residential. That does fall into that bucket and basically it just becomes bonus depreciation, which can be a big boon for people who are doing custom build outs or you're doing a lot of work to the interior of a short term rental. That could help you there. All right, so let's put some rubber to the road. What happens if we actually sell a property? What ends up happening here?

[Nate]

Yeah, so this is where the allocation piece is very important. Right. I actually don't think people discuss and talk about this enough. A lot of times when I buy the short term rental, it's fully furnished. Right? Fully furnished property. And then of course we always ask, hey, what was the value of the furniture? And they go, oh, I don't know. They never, they don't know. It's just included in the price of the cost. Well, that's important for us because one that helps us figure out what's the seven year property you can depreciate in this case. Right. So that's important also that might be something we have to allocate gain to. Right. The sales price too. Right. Because like whatever, when this happens, basically there are different ways that we can allocate the sales price. Right. This is actually how we can mitigate our depreciation recapture. Maybe we should have led with this. But basically this is a way, this is a strategy. They're calling them a reverse 1245 study now is what they're being Called essentially what these studies do is, is all they do is they say, hey great, in your property, we're looking at the items that honestly are not valuable to the buyer.

[Tom]

Right.

[Nate]

The buyer may care about the fact that there's a spa or hot tub or whatever. They might care about that, they might not care about that. And basically it allocates the value across the board to where hopefully we can allocate more value to what we call the 1231. Right. The land and the actual structure and bones of the building. So that way we reduce sort of depreciation, recapture and increase our 20% capital gains type property. That's the whole game of it. Because land and the actual bones of the building that is going to be taxed at the 20%, maybe 23.8% depending on the net investment income tax allocation. Right. If you're passive, not passive in the property, that's the next consideration there. But that's why it becomes a negotiation because the buyer wants to have more allocated to that 1245 type property. Right. So they can get a bigger deduction. Right. If you're a short term rental buyer, you would like to pull out that furniture cost because that's easily I get to immediately bonus appreciate that. While on the flip side the seller that doesn't, they want to allocate more to the land and structure than otherwise. Right. So that's why it's important to have that type of discussions. Right. Like there's actually a specific form. If you're buying a business, you have to have throw this all on. You don't have to do that in real estate. Right. The actual settlement agreement is pretty much all we need there for that. But it's an important discussion and I don't think people talk about it enough times. What are your thoughts on the allocation piece of this?

[Tom]

Yeah, I mean I've heard about this consistently throughout my career and there's always been some, you know, what ifs around it or what have you. But yeah, at the end of the day there's certain components of the property that are worthless and are not actually being sold or conveyed or whatever the case may be and you could avoid some recapture on it, you know. Phenomenal.

[Nate]

Right. And so talking specifically about like short term rentals right there. But like the one that I actually see this play out a lot in is anyone that owns like commercial build outs. Right. And so you've. Let's say you've got a physical therapist in one. Right. And they move out. Right? They move out. And so now you have a hair salon, someone who runs a hair salon, move in. Well, they will not want the same types of buildings. And so if you give a build out allowance and you own all the tenant improvements yourself, then great. That means now you get to remove all of that, get a partial asset disposition, and it's actually worthless to you if you decide to sell the building down the road, because all everyone cares about is the shell at that point in time. So if you have a warehouse and it's structured for one type of a customer and you're going to like tear it all down and then put someone else in there, that's totally separate, like new customer needs, new things, new build outs, tenant improvements, et cetera, Then you don't care about what's actually on the inside. Right. All the improvements that were made, you don't care about. That's not valuable. What's valuable is the actual structure and land that it's associated with. So if you can make those allocations and get that in writing and agreed upon, that's awesome. That's a really good strategy in my opinion, to actually make this happen. So just FYI on that piece, we try to do that for our clients as well. Right. We try to have conversations about what the buyer wants. Obviously we need that type of stuff in writing. But I think it's a really great mitigation type strategy.

[Tom]

Yeah, no, for sure, for sure. So, you know, bonus depreciation or depreciation, general, very valuable tool. And if we can mitigate the recapture, that is even better. And that kind of brings us right into some exit strategies that can help you exit properties and defer recapture as well as capital gains in many cases. And the first one being the good old Handy Dandy 1031 exchange.

[Nate]

Yeah, Tom, the golden handcuffs I like to call her. But basically I'm going to go through our buckets again. Our 1231 gains, always 100% deferable. We can use a 1031 exchange to do that, assuming it goes from like kind to like kind property. That's the key here. That has to be real estate to real estate. That's what we have to do. Then the question that I get a lot is can you defer 1245 and 1250 recapture? And the answer is yes. The answer is yes. However, you must do a cost irrigation study on the new property that you're getting into. Right. Your replacement property. That way you can figure out what your 1245 and 1250 buckets. And there actually is another way to like there is some Guidance that says maybe you can do it. However, I recommend having a conversation with us because there's a lot of information with that. So just FYI, if you want to have you curious about that, click in the show notes below to have a conversation with us. But basically there's ways you can defer the 1245 and 1250. Again, this is a kicking the can down the road type of conversation. It's not actually a tax elimination strategy, right, Tom?

[Tom]

Yeah, no, it's not always with a 1031. You go back and check out some of our prior episodes where we go more in depth on 1031s and we break it down. But long story short, you're just deferring the tax until some later point. If you eventually sell the property that you end up buying without doing another 1031 exchange, you would ultimately, you know, the chicken comes home the roost, as they would say, and the taxes do become due. But that is just something to be aware of and to plan around with your near advisor, for sure. Next we have though, the step up in basis, the good old hold till you die strategy where your heirs get the property at the fair market value at the date of your death, which means basically whatever your adjusted cost basis is, it just gets eliminated and their basis becomes the fair market value. And that eliminates all of the capital gains and all the depreciation recapture that you would have paid had you sold during your lifetime.

[Nate]

Yeah, right. Swap to your drop, Tom. Right. As everybody says, oddly enough, I think that the IRS released some statistics that they have via data that basically they're saying that you get to actually most people like less than like only 10% of 1031s actually go till death and then get the step up. Right? So basically what that tells me is that everyone goes, at some point I have to capitalize and cash in on my equity I've got right now as basically what I'm hearing. That's true or not. If it's multiple times, they want people I don't know. Right. That's the thing about statistics. It doesn't, we don't always have the data that goes into it, but it's just an FYI there, right? So look, I know a lot of people like buy, borrow, die, right? This is a fantastic strategy for that because your inheritors descendants, whoever winds up taking over what you've built up for this one generation, you now get the opportunity to pass it down to them. They'll get the capitalize on the equity, pay off the debt, pay no tax Right. Always the number one cost, always like it's always higher than interest, higher than anything else is our number one cost we have to deal with typically. So just FYI, that's of course a strategy. However, I don't recommend death as a strategy in of itself. Let's not go off, let's not go into that. But it can be helpful as an estate planning tool.

[Tom]

Absolutely.

[Nate]

And so then next time, the one that like we people talk about a lot or have considerations on is the installment sale game. And basically this, what this just means is that you get to recognize, you get to spread the gains and manage your income levels over time. Now there's one catch with this, just FYI, you cannot defer depreciation recapture. Right? So that's the one thing if you decide to get into, let's say a seller's carry note or something like that, or for a hotel commercial building, that's typically what I see the industries for. If you decide to do that, even if STRs actually I think about that. But basically what that means is you can spread the gain across years. However, you cannot actually do that for depreciation recapture. So if you have, going back to our earlier example, $400,000 recapture in the year of sale, you have to recognize it that year.

[Tom]

Yeah, no, for sure. And that could be a planning tool. Installment sales can be a tax planning tool to help you mitigate the exposure to capital gains. However, more often than not, at least from what I've seen, I've seen people use it as a selling tool actually, or an investment tool to be able to get access to properties with better financing than maybe they can got from banks and like to the seller, they usually get better terms on what they're looking for or can can get better terms and then they get a nice little tax perk for it. But from a tax planning tool in and of itself, there are certainly times when you'd want to take a look

[Nate]

at this 100% tom. And so that's one strategy installment sales is definitely think about. Also don't forget guys in this bucket, you have to remember that net investment, income tax matters. So if you're passive and not actively working in the property at this stage, get an extra 3.8%. You got to deal with hair. Right suggestion. FYI there. So another one to think about too that I have seen, you've seen a lot of people consider is the 121 exclusion. Right? What is that? That's the home gain exclusion ultimately. And basically what this means, hey, if you A lot of people do this, right? You buy a residence, it's in a good location, good spot, and so now you rent it out for a few years. And now you get the ability to get part of that gain totally excluded, except with some caveats. What are those, Tom?

[Tom]

Yes. So the caveat is that when you've rented out your property, after you lived in it for two years or three or however many years you lived in it, then you're going to start depreciating that property. And then when you go ahead and sell using the home sale exclusion, you're still going to have to pay tax on the depreciation recapture or depreciation that you've taken the gain from. The time you own the property will be tax free. But after you started renting it out, things do change a little bit there. And you will have to pay tax on the depreciation recapture and also the gain that's not attributable to the time you live there. It's like a little calculation.

[Nate]

Yep, totally. There are partial exclusions that exist for this too. So if you only live there for part time and you, you had to move, let's say to move for one work, a medical reason, there's like, there's options, there's ways that you can get this partial exclusion take, you can actually utilize it. So that's awesome. Just FYI that it exists, but you can never avoid depreciation recapture. It always sticks with the property. Even if, let's say I've actually gone down this route, like, let's say you decide to transfer it to your kiddos earlier, right. And so you want to transfer it to them, the depreciation sticks, right? It doesn't go away. It always stays attached to the property. So if they decide to sell it down the road, they would stop the deal with the depreciation recapture. So just FYI on that part too. And also there is an ability, if you have a rental property that was your home, that you can actually do a 1031 and 121 exclusion together. That is possible. Now we get this question. A lot of people go, oh, I want a 1031, my primary residence. That that doesn't work. What does work is if you took your primary, turned it into a rental property, and you're still within the home gain exclusion timeframe of two of the last five years, then that's possible to then do a 1031 with. However, that's not possible completely if you're doing the inverse of that, which would be rental property home 1031.

[Tom]

All right, so we do have a few frequently asked questions that do kind of come across our desk here. We kind of covered some of these throughout the episode, but we'll, we'll tackle some of these that we may have covered already. This one actually, we didn't cover. I only own 50%, but took 100% depreciation. Do I recapture 100%? Long story short, you recapture 100% of the bone of the bonus depreciation that you took. Right? So if you held 50% of the property and your partner took 50% of the depreciation and you took 50% of the appreciation, you're going to recapture 100% of your 50% of the depreciation. They will recapture 100 of their 50%. Just, all things being equal, assuming we're not talking about using exit strategies or deferral or mitigation, something about just how does it work? You're allocated your 50%, they're allocated their 50%.

[Nate]

Yep, 100%, Tom. And then can I avoid recapture by converting to a primary residence? Partially. Right, you can partially do it, but that property's always tainted is the way I like to say it. So like I actually, people say, what if I run a short term rental on a place I want to live one day and I do it for five, 10 years and then I go there to move, Right. I decide I want to be a snowbird, right? That's fine, you can do that. Just FYI, the only real way to escape it is by the step of a death. Right, that we talked about. It's the only real way you can live there. Just know if you sell before the death event, then unfortunately that means you're going to get hit with the recapture. That's okay, right? That's a long time. You got a tax free loan, Right. They got to use that capital and build. So just FYI on that. So, last question, and also PSA guys in the show, note comments, submit your FAQs to us. Right? Submit your FAQs, anything that, any types of questions you have relating to this topic. Tom and I are always happy to answer those on the show and on our FAQ episodes that we have. So let's do that. Last question. We have, what if I never took depreciation? Tom, I think you kind of answered this one earlier.

[Tom]

Yeah. So if you never took depreciation, the IRS is going to assume that you did and they're going to charge you the depreciation recapture as if you took it anyway. So always take your depreciation that you're due again, bonus depreciation, accelerated depreciation, that's optional. And just do have that discussion with an experienced tax advisor who can help you navigate that. But you have to take the depreciation. If you don't take it, you can use Form 3115, which is a complex form to catch it up. However, one of my favorite quotes, an ounce of prevention is worth a pound of cure. So always try to make sure you're doing things right the first time. And having said that, if you are not working with a qualified tax advisor who could help you navigate real estate, small business and personal tax strategies, then we'd love to have a conversation with learn more about your situation, how we can help because again, a lot of times we see issues that we always have to fix that were preventable if someone just got the right advice at the right time. And if you're getting into the game of real estate, if you're in small business, if you're a high income earner, you need to be working with qualified professionals to help you make sure that you are making the right moves. So you're maximizing your tax savings and you're not making mistakes that could cost you money in the future. And also you just have clarity on your situation, how it's going to work. So again, that link is going to be in the show notes to this episode. If you do want to have that conversation, we'd love to hear from you. There's a. Nate, anything else on your end?

[Nate]

No, Tom, I think you covered it pretty well. Right? This is a conversation like if you're selling property this year, you need to get on the phone with us now or get on the phone with your tax advisor so that you can figure out what your cost of tax is going to be and then you can decide what you should do from an exit perspective like you were saying. So click that link in the show notes below and we'll be happy to have a conversation with you.

[Tom]

Yeah, absolutely. And one last thing I'll say on that is you should actually probably be having these conversations before you buy property when you have a chance, because your advisor might be able to help you set up your property for success in the beginning or help you at least be able to understand, you know, what types of properties would be able to give you the type of benefits you're looking for and how to navigate all of that. So not going to go too far into the rabbit hole there for today, but again, that link is in the show Notes and thanks again for tuning in and we'll be back next week on the next episode of the Tax Smart REI Podcast.

[Tom Wheelwright]

The Tax Smart Real Estate Investors Podcast is for general information purposes only and is not intended to provide and should not be relied upon for tax law, legal or accounting advice. Information on the Podcast may not constitute the most up to date legal or other information. No reader, user or listener of this podcast should act or refrain from acting on the basis of the information on this podcast without first seeking legal and tax advice from counsel in the relevant jurisdiction. Use of an access to this podcast or any of the links or resources contained or mentioned within the podcast show or Show Notes. Do not create a relationship between the reader, user or listener of the podcast and the host, contributors or guests. Any mention of third party vendors, products or services does not constitute an endorsement or recommendation. You should conduct your own due diligence before engaging any vendor. For more information, reference the show notes or description of this episode.

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