What is Depreciation Recapture

Written by : Sevya Turmen, Acorn Cyprus Estates

What Is Depreciation Recapture and How to Avoid It in Europe and How the System works in Northern Cyprus:

Real estate can provide investors with value from multiple sources, well-positioned properties can strive to provide consistent cash flow from operations, in addition to appreciation in the property’s intrinsic value. If you are a real estate investor, you could access this property value appreciation, either via a sale of the asset or a refinance of debt obligations.

However, when that real estate is sold, you could be liable for taxes on the gains, similar to other investments. This liability known as capital gains tax, is calculated as a percentage of the difference between the purchase price of the property and its sale price.

Unlike other investment rank real estate investors are able to deduct the value of the physical depreciation from their capital gains basis. Capital gains tax for real estate is the net appreciation in value - accounting for the appreciation in the property’s value - less the physical depreciation that has occurred over that period.

Welcome to the world of depreciation recapture…….

All about Depreciation and how it’s recaptured

To understand depreciation recapture, it makes sense to understand depreciation. And, to understand depreciation, it makes sense to understand that physical things -such as real estate become less valuable over time, due to physical deterioration and obsolescence.

To account for this depreciation of value, the Revenue Office allows you to reduce the property’s capital gains tax liability. Basically, upon the property’s sale, you can deduct a specified amount from the capital gains basis, for each year the investment was held.

In other words, you can spread the costs incurred in buying and improving your property (not including the land, which is not depreciable), over the asset’s useful life period. According to the Revenue Office the definition of “useful life” is 27.5 years for residential properties.

The Revenue Office allows you to depreciate a rental property under the following conditions.

• You own the asset (even if you are paying off a mortgage).
• You use the asset either as part of your business or as a rental property.
• That the asset has a determined useful life; it can wear out or loses value.
• The asset must be held for at least one year. If you buy a rental property in January and decide to sell it in December, you won’t be able to write off any depreciation against their capital gains tax liability.

Depreciation is a great tool for decreasing tax liability, especially with a long-term holding period. For example, if you buy a duplex for GBP 300,000 and put an additional GBP 50,000 into it for improvements, your total cost basis is GBP 350,000. Due to the fact that land is non-depreciable, you can’t use it to determine your depreciable basis. For this example, if we assume the value of the land is GBP 75,000, your depreciable basis is GBP 275,000 (GBP350,000-GBP75,000).

Assuming that the property is put into service immediately after you buy it, you can divide that GBP275,000 by its useful life of 27.5 years, giving you a depreciation value of GBP10,000 per year. Upon a profitable sale of the property, however, the revenue office will want that money back.

Let’s say that, after 10 years of being a landlord for the above-mentioned property, you want to get rid of it. You sell it for GBP 500,000, meaning you receive a tidy profit of GBP 150,000. But with depreciation recapture, you need to consider the following:

• Your depreciation during that 10-year hold will be 100,000 (GBP 10,000 x 10 years).
• Your adjusted basis in the property will total GBP 250,000 When you sell that asset for GBP 500,000, your total gain will be GBP 250,000 (the sales price of GBP 500,000 less the adjusted basis of GBP 250,000).

So how are taxes assessed? Assuming you are in the highest tax bracket, the portion of the gain attributable to a property value increase will be taxed at 20%. In this example, that would be GBP 150,000 (GBP 500,000 - GBP 350,000). As mentioned earlier, the Revenue office will want to recapture any depreciation that was taken, which would be GBP 100,000 taxed at a 25% tax rate. When the tax dust settles, this means you’ll owe GBP 55,000 on a GBP 500,000 sale.

Exchange to avoid recapture

Another way to avoid depreciation recapture is by selling the property for less than its book value, which wouldn’t make much sense. Another solution is to hold onto the asset until you die. When that duplex becomes part of your estate, the cost basis is reset to the market value, meaning.

And What about in Northern Cyprus:

The payment of VAT depends on two factors:

• Whether or not the transaction is subject to VAT. This depends on whether the Vendor is deemed by the Tax Office to be a ‘Professional Vendor’ (i.e. whether the transaction is of a commercial nature or for profit). If the Vendor is deemed to be a Professional Vendor, the transaction will be subject to VAT. If the Vendor is a private individual, and not a Professional Vendor, the transaction will not be subject to VAT. ‘Vendor’ in this context, means the person who has title to the property, not simply possession/Contractual ownership of the property. So, with re-sales for example where the person selling the property does not have title to the property, but is simply assigning his or her Contractual rights in the property to the new Purchaser, the fact that he or she is a private individual not a Professional Vendor is irrelevant. If the person who is registered on the title deeds as the owner is a Professional Vendor, VAT will be payable.
• Terms of the Contract of Sale. If the transaction is subject to VAT, who will actually pay the VAT depends on the terms of the Contract of Sale. Previously, the Transfer Fee was generally paid as a percentage of the Assessed Value of the property which is calculated by the Land Registry just before transfer of title takes place. The Land Registry assesses the property in the state it is in at the date of the assessment i.e. if there is a new construction on the property, this will be included in the assessment of the value of the property. However, under new regulations, the Land Registry requires sight of the Contract of Sale before transfer of title and will calculate the Transfer Fee on the higher of either the Assessed Value or the Contract price.

The VAT and Capital Gains Tax again used to be based on the Assessed Value of the property. However, under new regulations, the Tax Office now requires a copy of the Contract of Sale to be presented prior to transfer of title. It will then calculate the VAT and Capital Gains Tax based on either the Assessed Value or the Contract value, whichever is the highest.

Every private individual has a once in a lifetime tax free sale option for a house and land not exceeding 1 donum (14,400 square feet or approximately 1338 square metres) provided that there are no trees recorded on the title deed. Should the land exceed 1 donum in size, the once in a lifetime tax free sale option may be used in connection with the property and the first 1 donum and so Capital Gains Tax will be payable upon the remainder of the land at 2.8%. Should the title deed refer to any trees, the once in a lifetime tax free sale option may be used in connection with the property situated upon the plot, but there may be Capital Gains Tax payable upon the value of the land at 2.8%.

On all subsequent sales, Capital Gains Tax will be payable at 2.8%, provided you do not sell more than 3 properties in one year, making you a professional Vendor. For professional Vendors, there are no tax exemption rights. Capital Gains Tax is payable on every sale at a rate of 4.7%.