They buy a property, hold it for a few years, sell it for a nice profit and then get blindsided by something called “depreciation revaluation.” Suddenly, the $100,000 win they were celebrating turns into a much smaller check after Uncle Sam gets his cut.
This happens all the time. And it’s almost always avoidable if you understand how property taxes actually work before you start investing.
When you own investment property, the IRS allows you to deduct the depreciation each year. It is one of the biggest tax benefits of real estate investing. You’re essentially writing off some of the property’s value each year, even though the property may appreciate.
On paper this is fantastic. Depreciation can offset your rental income, reducing your tax liability while you own the property. For many investors, this is the difference between a good and a great real estate investment.
But here’s what most people don’t realize until it’s too late and the fact is that the IRS wants that money back when you sell.
Revaluation of depreciation is exactly what it sounds like. The government gave you a tax break while you owned the property. When you sell, they recapture that benefit by taxing you on the depreciation you took.
Let me go through a simple example to make this concrete.
Let’s say you bought a rental property for $100,000. In five years you have written off €50,000 of that value on your tax return. Now your “basis” in the property (your cost minus depreciation) is $50,000.
Then you sell the property for $200,000.
Most people look at this and think: “I bought for $100,000, sold for $200,000, so I have $100,000 in capital gains. At 15% capital gains, that’s $15,000 in taxes.”
But it doesn’t work that way.
Since your basis has dropped to $50,000 (thanks to the depreciation), the IRS sees a total gain of $150,000. And here’s the painful part: the $50,000 in depreciation revaluation isn’t taxed at the capital gains rate. It is taxed at your normal income rate, which for high income earners can be 32%, 35% or even 37%.
So instead of $15,000 in taxes, you may owe $15,000 on the capital gain plus another $17,000 or more on the renewed depreciation. That’s a big hit that catches many investors off guard.
Here’s something that will blow people’s minds…
You owe the charge even if you never made the charge.
I learned this the hard way. Early in my investing career, I didn’t fully understand depreciation, so I simply didn’t claim it on my returns. I figured if I didn’t get a tax break, I wouldn’t owe anything when I sold.
Wrong.
The IRS taxes you as if you made the depreciation, whether you actually did or not. So if you don’t claim it, you get the worst of both worlds: no tax benefit as long as you own the property AND full depreciation upon sale.
If you’re a landlord and you’re not receiving a depreciation on your rent, you need to fix it immediately. You leave money on the table and still get the bill later.
The good news is that there are legitimate strategies to minimize or delay the resumption of charges. You just have to plan it.
1. 1031 Exchanges
The most common strategy is a 1031 exchange. Instead of selling your property and paying taxes, roll the proceeds into a new investment property. As long as you follow the IRS rules (tight timelines, qualified intermediary, similar property), you will defer both capital gains and depreciation recapture.
The key word is ‘delay’. The revaluation of depreciation does not disappear. It follows you to the new building. When you finally sell without doing another 1031, you will owe taxes on the total depreciation of all properties in the chain.
But if you pass through properties through 1031 exchanges, you can defer those taxes indefinitely.
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