Depreciation Recapture: The Tax Minnesota Landlords Forget About Until Closing Day

Ask a landlord what he will owe when he sells and he will usually talk about capital gains. Fifteen or twenty percent, he says. Not fun, but manageable.

Then his CPA runs the numbers and there is a second line he did not expect, and it is often bigger than the first.

That line is depreciation recapture. Here is what it is, why it is bigger than you think in Minnesota, and what you can do about it.

What depreciation gave you

When you bought your building, the IRS let you deduct its cost over 39 years for commercial property or 27.5 years for residential. If you did a cost segregation study, you pulled some of that into five, seven and fifteen-year buckets and wrote it off much faster. I recommend cost segregation for long-term holds. I do not recommend it for flips, and this article is why.

Every year, that deduction reduced your taxable income. On a $2 million building, straight-line, that is about $51,000 a year of deduction. Over twenty years, roughly $1 million of income you never paid tax on.

It also reduced your basis by the same amount. That is the part that comes due.

What the IRS takes back

At sale, your gain has two pieces. The part that comes from the building going up in value is capital gain, taxed federally at 15% or 20% depending on your bracket. The part that comes from the depreciation you took is "unrecaptured Section 1250 gain," taxed federally at a flat 25%.

It does not matter whether the building actually appreciated. If you bought for $2 million, took $1 million of depreciation, and sold for $2 million, you have no appreciation and a $1 million recapture bill at 25%. That is $250,000 on a building that "did not make any money."

If you cost-segregated and wrote off personal property, that portion is recaptured at ordinary income rates, which can be higher still.

Why it is worse in Minnesota

Three reasons.

• Minnesota has no capital gains rate. Gains are ordinary income, taxed at rates up to 9.85%. Recapture gets the same treatment.
• The 1% surtax. Minnesota adds a 1% net investment income tax on investment income above $1 million in a year. One good sale puts a lot of owners over it.
• The federal 3.8%. The net investment income tax applies to the whole gain, recapture included, for most passive owners.

Stack it up on that $1 million of recapture: 25% federal, 3.8% NIIT, 9.85% Minnesota, maybe 1% surtax. Almost 40 cents on the dollar, before you even get to the capital gain on the appreciation. Rates and laws change and your situation is unique, so run this with your CPA. But do not be surprised by it.

Three ways to defer it

1. Keep the building. Recapture is only due when you sell. Hold until death and, under current law, your heirs get a stepped-up basis and the recapture disappears. This is a real strategy. It is also why so many tired landlords in Edina still own buildings they stopped enjoying in 2015.

2. 1031 exchange. Sell, reinvest through a qualified intermediary within 45 and 180 days, and both the capital gain and the recapture roll into the new property. You keep managing real estate, but you keep the money working. The comparison is here.

3. 721 contribution. Contribute the building to a partnership, in our case AlphaDiv Real Estate Fund, in exchange for units. Gain and recapture are generally deferred at contribution, subject to the debt-relief rules of Section 752, and the deferral continues as long as you hold the units. You stop managing, you keep the income, and your heirs inherit units instead of a roof. How that works, with a real example, is here.

The mistake

The mistake is finding out about recapture at the closing table. By then you have signed a purchase agreement, the buyer has a lender, and your options are gone.

Ask your CPA for a sales-proceeds-after-tax estimate before you talk to a single buyer or broker. If the number makes you flinch, that is the moment to decide between holding, exchanging and contributing. Not after.

And if you want a second set of eyes on the building itself, we buy in the Twin Cities every month and we are happy to tell you what it is worth and what your options look like. Written, within three business days, no obligation.

Educational only. Not tax advice. Federal and Minnesota rates cited are current-law approximations and depend on your bracket and filing status. Consult your CPA.

Mike Sowers, CCIM founded Commercial Investors Group in 2005 and is the Managing Member of AlphaDiv Real Estate Fund. He is the author of the Amazon bestseller Commercial Real Estate Investing and host of the CREative Commercial Real Estate Show. mike@cre-fund.com