One of these is a little-known tax term: depreciation recapture. What is depreciation recapture? And how can you ensure that it doesn't give you a big tax bite? Here are a few answers.

What Is Deprecation Recapture?

When you purchase a long-term and expensive business asset, you can't simply deduct the entire cost of the purchase as an expense in the year you buy it. What you must do is known as depreciating the asset. Depreciation divides the money you spend on the asset by a certain number of years (often referred to as its useful life) and allows a partial deduction each year. 

Deprecation becomes an expense that reduces your taxable income each year. However, when you sell the asset, you then must recapture all those deprecation deductions as a lump sum. Why? You received the tax benefits each year when you deducted depreciation. 

For example, suppose you own a $1,000 appliance and it depreciates $100 per year for seven years. When you replace the appliance, you sell the used item for $400. Since your investment (basis) in the item is now $300 ($1,000 minus $700 depreciation), you don't have a $600 loss upon sale. In fact, you would have a $100 gain taxed as ordinary income. This is the lesser of the amount taken as deprecation or the gain on the sale.

How Does Recapture Affect Landlords?

Landlords, like nearly all businesses owners, have at least some normal depreciable assets. This often includes appliances, technology, business vehicles, and large pieces of equipment. Each purchase should be properly depreciated when necessary - rather than taken as an expense - and accounted for when disposed of. The result is often not a taxable gain. 

In addition to normal business assets, though, landlords face an additional tricky situation. Unlike these smaller assets, most real estate actually rises in value. So while many assets result in a loss (on paper) when sold, buildings and houses tend to result in gains. As a landlord, you need to know what the taxable result is since it can be surprisingly large.

In addition to facing a tax bill due to appreciated assets, real estate also may be subject to different recapture provisions within the IRS code. Different categories of real property, such as a standard building versus a specialized structure, may see its recapture fall under Section 1245 or Section 1250 of the Internal Revenue Code and therefore be taxed at different rates.

How Can You Minimize Taxes?

So if you must face recapture taxes, how can you make the best of it. There are several legitimate ways. Some landlords can immediately invest in what is known as like kind property and perform an exchange, which may delay taxable income until the new asset is sold. You may also find that selling during a period of low income helps keep your ordinary income and recapture tax rates low. 

The key to minimizing any landlord tax bill is to learn how to make the wisest use of expenses and assets. At Bliss & Skeen, our tax professionals can help. Call today to learn more about depreciation, recapture, like kind exchanges, or other potential tax implications of your landlord enterprise.

Consulting in advance of business decisions will help you make the smartest choices and reap the biggest rewards.