When selling an investment property, many California investors are often surprised to find the gain they owe taxes on is much larger than expected. This is because the IRS doesn’t calculate profit from the original property price, but instead uses the adjusted basis, which is the original purchase price minus any depreciation claimed over the years.
Depreciation is the annual deduction the IRS allows property owners to take against their income to account for the theoretical wear and tear on a structure. Residential investment properties depreciate over 27.5 years, and commercial properties over 39 years. While this deduction reduces taxable income each year the property is held, it also quietly lowers the adjusted basis, which means the taxable gain at sale is higher than it would otherwise be.
Depreciation recapture is how the IRS collects on those prior deductions when the property is sold. The total depreciation claimed over the holding period gets "recaptured" and taxed as ordinary income, up to a maximum rate of 25%. This is separate from and in addition to the capital gains tax on the remaining profit.
Capital gains tax then applies to the difference between the sale price and the adjusted basis, beyond the recaptured depreciation amount. For example, if a real estate investor held the property for more than a year, that gain is taxed at the long-term capital gains rate, which is 0%, 15%, or 20% depending on their income, plus a potential 3.8% net investment income tax for higher earners.
Together, depreciation recapture and capital gains taxes can consume a significant portion of the proceeds sale, often 30 to 40 percent or more of the equity you've built, depending on your tax situation and how long you've held the property. This is precisely why tax deferral strategies like a 1031 exchange can make such a meaningful difference for investors looking to preserve and grow their wealth.
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At Legacy Investments & Real Estate, we work with investors who are weighing a sale and want to understand all of their options before the clock starts. We’ll help you evaluate replacement property strategies and build a plan that fits both your financial goals and your life.
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There are material risks associated with investing in private placements, Delaware Statutory Trusts (“DSTs”) and real estate securities including the potential loss of the entire investment principal, illiquidity, tenant vacancies impacting income and revenue, general and real estate market conditions, lack of operating history, interest rate risks, competition, including the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and investors should read the PPM carefully before investing paying special attention to the risk section. This material is not to be interpreted as tax or legal advice. Please speak with your own tax and legal advisors for advice/guidance regarding your particular situation. Securities offered through Concorde Investment Services, LLC (CIS), member FINRA/SIPC. Advisory services offered through Concorde Asset Management, LLC (CAM), an SEC registered investment adviser. Legacy Investments & Real Estate is independent of CIS and CAM.