Posted by Dave T on October 22, 2000 at 22:10:43:
Let’s say you buy a SFR for $35000 to use an an investment rental. After three years, the market demand for property similar to yours has caused a significant appreciation. You decide to sell the property for $50000. Your capital gain on the property appears to be $15000 and this profit is taxed at a 20% capital gains rate.
Since you used the property as an investment rental, and should have taken a depreciation expense during your investment use, the actual cost basis in that property is reduced by the amount of depreciation taken (or the depreciation you should have taken, whichever is greater). For the sake of illustration, let’s say that you allocate $7500 of your $35000 purchase price to the value of the land and $27500 to the value of the building. Now during your three years of investment use, your straight line depreciation expense should have been $3000 or $1000 per year.
Your cost basis is now $32000 (purchase price minus depreciation), making your taxable profit on the sale of this property $18000. Now you can readily see that $15000 of your profit is due to market appreciation (20% capital gains tax rate), while $3000 of your profit is due to the depreciation taken. The $3000 of profit due to depreciation is taxed at the depreciation recapture rate of 25%.
Hope this helps answer the question.