Depreciation Recapture Questions

12 Replies

I bought a condo in Laguna Niguel CA in December 2009 (7+years ago).  I lived there one year then bought a bigger home with my new wife.  I continued to own and rent the condo.  Cash flow in coastal CA is very hard to get because property is very expensive and rent is low in comparison.  I started with a small negative and currently have a small $170 positive cash flow per month.

I bought for $365,000 (then added around $17,500 in improvements) and currently could sell with a realtor for about $550,000. 

Well over $11,000 per year of principal is being retired on the 20 year loan.  Same great tenant all these years. He now wants to buy it and I am checking it out.  He wants to buy at about $520,000 which would be fine because I would save on realtor fees and would not have to paint, replace carpets etc (no need to fix up to show the property).

I've saved lots from the $13,635 depreciation per year (13,635 * 7 years = 95,445). But I never knew about the Depreciation Recapture rule. When I sell it I will get a check for about $300,000. I thought all profit/appreciation would be at 15% long term capital gains rate. But it sounds like I will have to pay closer to my ordinary tax rate (25% fed + 9% CA) on the $95,445 that I have already depreciated.  Wow!! Does this sound right?  If so I may retire now to put me in a lower tax bracket for this 2018 sale.  Then maybe start a business in 2019 (I'm currently 58).  

This property was great with the price appreciating and using the depreciation rules to lower my very high taxes. But now it seems if I sell I will have to pay back all the money that I saved from depreciation because of the recapture rule.  Can anyone shed more light on this rule?

I would like the $300,000 but don't really need it.  But the time is right because with these rising interest rates fewer buyers will be able to afford this property in the future.  On the other hand if I keep it for ever I never have to pay back the depreciation savings.  But this will leave me with my small positive cash flow until the 20 year loan is payed off in 13 years.  At that time I will have a huge positive cash flow but do I really want to wait 13 years for that?  

Last year I bought my first mid-west property - Burlington KY (northern KY), this is really a suburb of Cincinnati. I do like the cash flow, I may do another one or two in same area this year.  If I re-invest my profits from CA in new properties in mid-west would that save me from having to pay the depreciation recapture etc?

Any thoughts or insight is appreciated. 

@Brad Rondeau  

Unfortunately retiring to put you in a lower bracket doesn't really help. The profits from the sale of the home also determine your tax bracket...so it would bump you back into a higher one. 

If you have taken $95k in depreciation then yep- you will be paying 25% on that amount. 

And capital gains rates on the profit of the sale. 

You can look into doing  1031 exchange if you'd like to own another rental- that will defer all taxes, including depreciation recapture. 

@Brad Rondeau , if you're in the 9% CA tax bracket then you also have to add that to the Fed cap gain.  Correct me if I'm wrong @Natalie Kolodij but I don't think CA differentiates between capital gain and other income.  Income is income.  So Brad you could end up paying 34% on the depreciation recapture and 24% on the capital gain.  I read somewhere that CAs combined tax rate was 2nd highest in the world behind Denmark - no bueno.

A 1031 exchange would allow you to go into some more of those properties you like in the midwest.  and the tax you defer would just about pay for a couple of them.  Something to think about.

yes, if it is 25% plus 9% that would be a killer.  Looks like I need to check into the 1031 exchange.  Say I become a resident of a low tax state, then sell the CA property.  Would that get me out of the 9% CA tax or would I still owe the CA rate?

@Brad Rondeau I don't know your income level, but based on your description of the cash flow over the years, you may very well have large suspended losses that get released when you sell the property.  So this may alleviate the pain a bit.  But if you are serious about out of state investing then as others mentioned a 1031 sounds like it may be the way to go.

@Brad Rondeau , Welcome to the world of the California Clawback.  If you 1031 exchange a property from CA to any other state CA will still require you to file a report every year until you finally sell that or any other descendant properties without a 1031 exchange.  Then CA will still collect the appropriate tax from the gain deemed earned while the property was in CA.

@Logan Allec has a good idea of looking at your suspended losses first.  Other than that just keep kicking the can down the road and make CA wait!

Make sure you've excluded any land you own from the depreciation calculations.  From your annual depreciation amount, it looks like your depreciating the entire cost.  If you didn't buy any land, you're fine. 

1031 if you don’t need the cash now, that’s a lot of tax to pay.  Talk to a good QI like @Dave Foster for that part of it and then start looking at potential replacement options, including real estate securities (DSTs, TICs) if you are accrefited and pure real estate deals (single owner).  If you talk to the right professionals, you’ll be able to identify several strategies that will meet your future cash flow and exit strategy goals.  It’s a bit much to go into on a post.....  PM me and let’s have a call and I can give you a few ideas.  

Just pay the tax, wash your hands and move on, sounds like your doing well overall.

But why are you selling at all, hold for ten more years and sell for 685,000.  

yes, great advice to look for suspended losses.  I've been working so much at my real job I have not had time to keep track of investments/taxes.  It seems like $150,000 AGI income is some magic number and most years I was above that so could not take losses.  I see one year where I was below $150,000 and my tax prepare-er took some losses from prior years (but this prepare-er has made many mistakes and I have moved on from him).

One more question.  Can I move back in the property for one year and then sell as my owner-occupied property?  Are there some benefits there?  I'm guessing I would still have to deal with the depreciation re-capture. 

So I still have the same questions below.

Can I move back in the property for one year and then sell as my owner-occupied property? Are there some benefits there? I'm guessing I would still have to deal with the depreciation re-capture.

Also, I have been looking at the new lower tax rates on the tax foundation web site which is good.  But I'm guessing the profits from the sale would really push me up into a higher tax bracket (for the depreciation recapture).  Just wondering if there are any strategies there as the being pushed into the higher fed brackets plus the high CA rate would be tough to take.

The 1031 is an option but seems to just delay the inevitable fact that this depreciation recapture will have to be paid at sometime in the future.  Also, trying to simplify my life and it seems like the 1031 would add some degree of complication in the future.

I've been hammered by taxes for the last server years and thinking of retiring from my regular job just to get in a lower bracket - then manage all my investments more efficiently.

@Brad Rondeau , You'd have to move back in for two years to get the primary residence exclusion.   And you would still have depreciation recapture.

The 1031 adds a level.  I guess it depends on how much that tax savings provides motivation.  If you wanna pay the tax now that has it's own level of complications.  If you're going to continue investing in real estate then every year you don't pay the tax adds money to your pocket from the return that you get off the deferred tax and deferred depreciation recap.  So you can pay now, or pay later and make some money for a while.

Or follow the path of more than a few people and pay never.  1031 into a passive cash flow producing instrument at some time and never sell at the end.  If you never sell without the 1031 you'll never pay tax on the gain.  You'll never pay depreciation recapture.   And your heirs get the property at a step up basis so the gain goes away for them.