If you own a home and have spoken to a CPA about it, you may have heard the term "depreciation recapture". What is it and why is it important?
When someone starts renting their home, they are allowed to use some of their expenditures to offset their earnings.
So if you buy a home, shouldn't you be able to use the entire expense in the first year? Unfortunately, no, you can't.
The IRS follows a "matching principle", where they allow taxpayers to take the expense for assets with long life (>1 year), over time.
The philosophy behind this is that taxpayers should match the cost of an expenditure reported with the approximate benefit that it has provided.
Since they estimated that a rental home should last approximately 27.5 years, that's the period of time that a taxpayer can recognize the expense of the home.
However, a home doesn't behave like most assets. Compared to a car, which generally decreases in value over time, a well-maintained home usually does not decrease in value, and when sold, often fetches a selling price that is more than the purchase price.
This doesn't happen too often with most other business assets. So how does the IRS expect us to report a rental home sale?
The Internal Revenue Code has already allowed you to report expenses on a rental home through depreciation, even as your rental home was increasing in value, so at the time of sale, the IRS requires a "depreciation recapture" - the taking back of a benefit (depreciation expense) that you were allowed to take advantage of but wasn't rightfully earned.
By "...wasn't rightfully earned...", I do not mean the taxpayer was doing anything improper. What I mean is that the philosophical underpinning of depreciation rarely works with a rental home maintained in good condition. Weird, huh?