Depreciating the capital gains tax owed on the sale of an investment property

10 Replies

I've got client with a question relating to capital gains taxes on the sale of an investment property. If you have any familiarity with capital gains taxes/depreciation please chime in.

He bought a single family house in Virginia in 1980 for about 65,000. It's primarily been a rental property since then. He's now looking to sell it for about 450,000, but he's concerned about his tax liability. Will the entire gain be subject to capital gains taxes? Or can some of it be depreciated, thereby reducing the tax owed? I don't believe any depreciation has been taken before. Yes, I know you are not providing tax or legal advice. Just curious to hear if people think the tax can be reduced and, if so, in what way.

Originally posted by @Dan MacDonald:

I've got client with a question relating to capital gains taxes on the sale of an investment property. If you have any familiarity with capital gains taxes/depreciation please chime in.

He bought a single family house in Virginia in 1980 for about 65,000. It's primarily been a rental property since then. He's now looking to sell it for about 450,000, but he's concerned about his tax liability. Will the entire gain be subject to capital gains taxes? Or can some of it be depreciated, thereby reducing the tax owed? I don't believe any depreciation has been taken before. Yes, I know you are not providing tax or legal advice. Just curious to hear if people think the tax can be reduced and, if so, in what way.

 Dan,

He is going to have recapture on the 65,000 minus the land value taken at that time.  That will be taxed at up to 25%.  He will then have capital gains on the remainder.


His only other option is to utilize a 1031 exchange to another property.  Otherwise leave it for his kids to inherit at a stepped up basis (doesn't always make sense).

It should be taxed as a long-term gain; 0-20% tax rate. The client could do a 1031 exchange into another property. Purchase a retirement home, rent it for two years, and then move into it. 

I'm not certain about the depreciation though and how that would work. An accountant would know best. 

Check out this article from the Washington Post.

My understanding is that the IRS treats all sales as if depreciation had been taken, whether or not the taxpayer actually claimed the depreciation. Check with a CPA.

Hi Dan,

Steve and Dan are both correct.  Depreciation recapture is computed whether the taxpayer actually depreciated the property or not.  There is no way to "reduce" it; it just is what it is, unless they want to 1031 Exchange into something else. 

Thanks for the replies everyone.

If I heard everyone correctly, the $385,000 gain will be taxed at the prevailing federal and state rates -- there's no way around that (outside of a 1031 exchange) -- but on top of that, there will be recapture of the amount depreciated while he owned the property. 

So there actually ends up being even more tax owed than what I originally thought was the worst case scenario. Bummer.

@Steven Hamilton II   could you give examples of when it does not make sense to

"leave it for his kids to inherit at a stepped up basis (doesn't always make sense)" ??

Are you referring to a large estate perhaps...

@Gautam Venkatesan  ,

When you inherit something it is at the Fair Market Value ont he date of death.

In other words if something has appreciated because it was purchased at say 60k 50 years ago and is now work 700k, the person that in herits it would use the value on the date of death.

@Steven Hamilton II   

I understand the stepped up basis on death. I was questioning in what scenario(s) you believe this is not a good thing?

One example would be if the kids will fight over inheritance.

If the property is in a declining area or is nt going to be appreciating very thoroughly.

@Dan MacDonald  

I have a different take on the question.  

First, if your client is asking about tax treatments, your response should be that he should pose the question to his own tax professional.  Someone who would know how to navigate all the complexities of the tax code and give an informed opinion can not be replaced by any answers you may get from well meaning but less-informed postings to an internet discussion forum.

Now here is my take.  Back in 1980, depreciation was straight line over the service life of the property.  The amount that could be depreciated was the cost minus "salvage" value (which would have included the land value).  At that time, depreciation simply adjusted the cost basis, and when the property was sold the difference between cost basis and the net sale proceeds was the taxable capital gain.  In effect, the depreciation was recaptured at the prevailing capital gain tax rate.  

In the early 1980's, MACRS was implemented which introduced a 15, 16, or 18 year class life for residential rental property, depending on the year the property was placed in service.  Again, depreciation simply reduced the cost basis and was included in the sale profit subject to capital gains.  

In 1986 MACRS was eliminated for rental property newly placed in service, and, depreciation for a residential rental property went to a straight line 27.5 year recovery schedule.  In 1997, the tax law separated the profit due to depreciation from profit due to appreciation and established a 25% tax rate for unrecaptured depreciation.  The tax code also specified that ONLY the depreciation taken (or that should have been taken) since May 1997 is subject to the depreciation recapture tax.  

The challenge for your client's tax professional is to determine how much if any depreciation should have been taken since May 1997, if any.  I suspect an aggressive position would be that the property should have been fully depreciated by May 1997. and thus there is no depreciation to recapture at the 25% tax rate.  

Unless there is relevant tax code that nullifies this position, it is worth paying a tax professional to figure it out if the property sale will be a taxable event.  In this case, your client should also inquire about ways to structure the sale to minimize or avoid the effect of AMT and/or the Medicare surcharge.    

I also echo the responses that suggest your client's best immediate tax outcome is probably a 1031 tax-deferred exchange.  But, that also is a question that is more properly addressed to a tax professional.  You should only suggest that your client address these topics with his own tax adviser.

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