Taken from article originally published 8th November 2023

While we’re only three days into the week, through our client US tax advice consultations, the issue of “depreciation recapture” has come up multiple times already. So, for those who aren’t already aware of the term, here’s a brief overview.

As is now widely known amongst US expats in New Zealand, the US is one of the few countries worldwide which ties tax residency to citizenship. This means that US citizens residing anywhere around the world, and earning income, are required to file a tax return annually to the IRS.

This includes all worldwide income, such as New Zealand wages, or income from a New Zealand rental property.

Article 6(1) of the NZ-US double taxation treaty addresses income from rental properties. This part of the treaty determines which country gets the “primary taxing right” of rental income. In essence, “primary taxing right” means the country which gets to tax the rental income first, whilst the other country must allow a credit against their taxes.

This article of the treaty states that the country where the property is physically located, gets primary taxing right. In practice, for an NZ rental property, this means that the IRD gets to tax rental income, and whilst the income must be reported again in the US return, a credit is allowed for those NZ taxes paid.

This makes US taxation on an NZ rental property, quite uncommon (as NZ taxes are generally higher than the US), with NZ tax credit offsetting US taxes in full.

As part of the process of determining rental income and expenses, the depreciation of the property is also factored in. Depreciation serves as an expense that offsets rental income. For rental properties put into service before January 1, 2018, the property is depreciated over 40 years. Properties placed in service from January 1, 2018, and onwards are depreciated over 30 years. To clarify, "placed in service" means when a property is made available for rent, regardless of whether it's immediately tenanted.

For those not familiar with the concept of depreciation, it involves gradually reducing the property's value for tax purposes, even though property values generally tend to appreciate in New Zealand, at least.

So, what exactly is the basis? From the IRS's viewpoint, the basis can be either:

For a newly purchased rental - The purchase price, plus legal fees, and property improvements.

For converted rentals (e.g., a family home converted to a rental) - Either the purchase price as mentioned above or the fair market value at the date of conversion, whichever is lower.

The basis is also used to determine capital gains when you sell a property, meaning that any sale price exceeding your basis is considered a capital gain and is subject to IRS taxation. Notably, for properties converted to rentals during ownership, there's a risk that your basis could decrease if market values fall below the original purchase price.

So, to explain further, whilst the IRS has a number of different types of taxes, the main ones affecting us here are:

Capital gains tax - Generally taxed at a lower rate of 15%.

Ordinary income - Taxed at a higher rate, depending on your tax bracket, with a maximum of 37% for 2021.

Finally, let's dive into the concept of Depreciation Recapture:

Imagine a US citizen purchased a rental property in New Zealand for $1,200,000 USD, including legal fees and improvements, and it was immediately put into service on January 1, 2023. As per the information above, the property's basis is $1,200,000, and it's subject to 30 years of depreciation.

Every year, $40,000 of the property's value is deducted as an expense against rental income. Fast forward to January 1, 2033, and the property is sold for $2,000,000 USD.

Now, we have to address depreciation recapture.

Over the course of 10 years, $400,000 in depreciation has occurred, reducing the property's basis to $800,000 from $1,200,000 (assuming no improvements were made).

Consequently, we have a $1,200,000 capital gain ($2,000,000 sale price minus $800,000 basis).

However, this $400,000 in depreciation must now be recaptured. So, out of our $1,200,000 gain, we'll have:

• $800,000 taxed as a capital gain at 15%.

• $400,000 depreciation recapture, taxed as Ordinary Income with a maximum rate of 37%.

In essence, the IRS reclaims the depreciation claimed over the past 10 years and taxes it at the higher ordinary Income rate.

It's crucial to note that depreciation recapture occurs irrespective of whether depreciation was actually claimed. In the case of an individual who hasn't been filing tax returns, upon the sale of a rental property, depreciation recapture will still calculate depreciation for all the years when no returns were filed, even if no actual depreciation benefits were claimed.

Its important to note that the above is an overview only, and should not be construed as tax advice.

If you own an NZ or US rental property and looking to better understand your obligations, contact us today on 09-242-3445 or dave@usatax.nz.