Homeowner · Corpus Christi, TX · Member since 2008 · 199 posts · 16 votes
I bought a rental (Town Home) back in 2004 & have been taking a depreciation so that I could get a bigger tax return. The CPA that did my taxes this year advised me that I shouldn't be taking a depreciation if I plan on selling (which I do in a couple of years) cuz I will have to pay capital gains on that amount. My goal is to make as much money off it when I sell it so should I stop taking a depreciation? Any advice would be great cuz I don't know much about investing.
Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
18y
This issue has been discussed a few times before. I'll wade in yet again, since I now have a new CPA who seems to actually understand real estate investing.
I assume you are referring to the straight line 27.5 year depreciation that's currently allowed, and not the accellerated depreciation allowed on some properties acquired long ago.
It is my understanding, confirmed by recent and in-depth conversation with my new CPA, that you will have to pay depreciation recapture tax on the amount of the depreciation when you sell the property. Depreciation reduces the basis, and so increases your gain on the sale.
This is different than in another thread where RECPATAXMAN and I discussed this point, and came to the conclusion that the depreciation recapture applied only the accellerated portion. Since accellerated depreciation doesn't apply to properties purchased recently (sincee 1987?), you wouldn't have to pay the recapture tax. According to my new CPA, which has extensive real estate experience, that's incorrect. Yes, there was a recapture tax for accellerated depreciation. Maybe still is, if you have a property under those rules. The recapture for the straight line depreciation is different and does still apply.
Its also my understanding that the basis for your property is reduced by the depreciation allowed, not the depreciation taken. So, doesn't matter whether you take it or not.
I'm sure you'll get other posters with different responses.
Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
18y
This issue has been discussed a few times before. I'll wade in yet again, since I now have a new CPA who seems to actually understand real estate investing.
I assume you are referring to the straight line 27.5 year depreciation that's currently allowed, and not the accellerated depreciation allowed on some properties acquired long ago.
It is my understanding, confirmed by recent and in-depth conversation with my new CPA, that you will have to pay depreciation recapture tax on the amount of the depreciation when you sell the property. Depreciation reduces the basis, and so increases your gain on the sale.
This is different than in another thread where RECPATAXMAN and I discussed this point, and came to the conclusion that the depreciation recapture applied only the accellerated portion. Since accellerated depreciation doesn't apply to properties purchased recently (sincee 1987?), you wouldn't have to pay the recapture tax. According to my new CPA, which has extensive real estate experience, that's incorrect. Yes, there was a recapture tax for accellerated depreciation. Maybe still is, if you have a property under those rules. The recapture for the straight line depreciation is different and does still apply.
Its also my understanding that the basis for your property is reduced by the depreciation allowed, not the depreciation taken. So, doesn't matter whether you take it or not.
I'm sure you'll get other posters with different responses.
Homeowner · Corpus Christi, TX · Member since 2008 · 199 posts · 16 votes
18y
Now i'm really confused about all this. I'm not going to lie to you guys & go ahead & tell you that I am clueless to all of this. I have never really took it series & now want to start doing the right thing. I have ALOT to learn cuz none of this makes sense to me.
Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
18y
I'm not confused, but after reading extensively on this topic, having previous discussions here on bigger pockets, and discussing it will two different accountants, I'm not 100% confident of the answer.
I believe the answer is that you have to pay depreciation recapture tax, currently 25%, on the portion of the gain on a sale that is attributable to the depreciation allowed on the property. Your basis is reduced by the depreciation allowed. The gain is the sale price (less all sales costs) minus the basis. The portion equal to the depreciation allowed (or the total gain, if less) is subject to recapture tax. The remainder is subject to capital gains tax.
I'm actually pretty confident about this answer. My new accountant is quite knowledgable and experienced, and spoke to both this form of recapture tax and the older accellerated depreciation recapture tax.
My understanding is that the IRS will consider you to have taken the allowed depreciation each and every year, regardless of whether you actually take it or not.
When you do sell it, that expected depreciation will be factored into the gain on the property.
I'm pretty suprised your accountant is telling you to not take your depreciation each year. From what I have seen there is really not a lot of wiggle room on it.
Contractor · Emeryville, CA · Member since 2009 · 14 posts · 5 votes
16y
Is there a way to make up for lost depreciation if you already have a rental but haven't been depreciating it (e.g. depreciate ALOT in one year or increase the depreciation amounts for the remainder of the useful life years?)
Accountant · New York, NY · Member since 2009 · 24 posts · 4 votes
16y
Hey Joey,
I think you would have to file amended returns. As of now thru April 15, 2010 (or Oct 15 if 2006 went on extension), you would be able to amend back to 2006 tax return. The rule is that the amendment deadline is 3 years after return due date (2006 return would have been due Apr 15, 07 or oct 15 on extension).
Let me know if that makes sense...
Wholesaler · Colorado Springs, CO · Member since 2009 · 286 posts · 255 votes
16y
Whether or not to take depreciation depends in part on what your estimated taxes will be for this year and the future. If you claim depreciation to offset income that you would otherwise be paying in a higher tax bracket, you can save money. If however you use depreciation to offset income that you're paying in a lower tax bracket it may be wise to hold off on claiming it until you are in a higher bracket.
For example, lets say you can claim $10,000 in depreciation this year when you make $50,000 pre-tax income. For mathematical sake let's say the tax at this level is 20%. What you are essentially doing is not having to pay 20% of $10,000 = $2,000.
Now in this same situation lets presume you have a lot on your plate that will be sold next tax year thereby increasing your income to $100,000 pre-tax. Since you plan ahead you decide to claim this $10,000 depreciation in the $100,000 pre-tax income year. Again for mathematical sake let's say the tax at this level is 30%. Now you're esentially not having to pay 30% tax on $10,000 = $3,000.
By choosing to take depreciation when you're in a higher tax bracket you are keeping more money in your pocket. Of course if you could better use $2,000 this year than $3,000 next year it might not be worth your while. It's important to plan your taxes accordingly.
Wholesaler · Colorado Springs, CO · Member since 2009 · 286 posts · 255 votes
16y
Joey,
If you missed any depreciation, and have owned the property for more than three years, you can get it back all in one year without havign to file amended returns (file amended return if it's less than 3 years).
You can do this by filing for automatic IRS consent via IRS Form 3115 - Application for Change in Accounting Method.
I can't go into details here (I'm not a tax advisor so I encourage you to seek one accordingly). The above information is from Albert Aiello's Goldmine of Brilliant Tax Strategies. Worth the investment if you are serious about real estate.
Contractor · Emeryville, CA · Member since 2009 · 14 posts · 5 votes
16y
Dave and Andy - thank you for the answers.
Andy, I have a follow-up question regarding your response about timing when to take depreciation. I was under the assumption that depreciation should be taken each year regardless because when the property is sold, the recapture is against the depreciation allowed, not taken. With your suggested strategy, it seems to imply that recapture is against depreciation taken. Is that true?
Real Estate Investor · Oakland, CA · Member since 2008 · 63 posts · 17 votes
16y
Hi Joey,
The recapture tax is applied to depreciation ALLOWED, or depreciation TAKEN, whichever is greater.
So in other words, lets say you took no depreciation, or less than the IRS says you were supposed to. The IRS will recapture based on the depreciation ALLOWED (determined by taking the straightline deduction over 27.5 years).
It is possible for depreciation TAKEN to be greater than depreciation ALLOWED, for example if you accelerated depreciation deductions, and in this case (when TAKEN>ALLOWED), the recapture is applied to depreciation taken.
Investor · Pawleys Island, SC · Member since 2008 · 1k+ posts · 837 votes
16y
Just to clarify the recapture rules.
Allowed depreciation is the depreciation taken. Allowable depreciation is the depreciation that was allowed but not taken.
When unrecaptured depreciation is taxed, the depreciation allowed or allowable, whichever is greater, is what is taxed at the 25% recapture rate.
Excess depreciation, such as the bonus 50% depreciation we have seen in recent years, is that depreciation taken that exceeds the depreciation that would have been taken on a straightline depreciation method.
Excess depreciation is recaptured at the taxpayer's ordinary income tax rate which may be higher than the 25% recapture rate.
Depreciation is not a mandatory expense, but take it each year it is allowable because you will be taxed on it anyway.
Anyone with a CPA saying anything different should get a new CPA.
Residential Real Estate Agent · Mt. Pleasant, SC · Member since 2010 · 257 posts · 130 votes
16y
Originally posted by Joe Wilson:
YES!!! take the depreciation, because it lowers your ORDINARY income, which is at higher rates (up to 35%) versus CAPITAL gain which is up to 20%.
Get another CPA.
Now this makes sense. I've been taking depreciation on my 1 rental property for 2 years, and always figured it would be a wash when I sold it, but it does actually save a few bucks in the long run. At least, until Obama raises the cap gains tax!
SFR Investor · Orange County, CA · Member since 2009 · 1k+ posts · 1k+ votes
16y
Don't sell... exchange!
At least that's my plan. With a 1031 exchange, you can upgrade that property into larger/nicer/higher income producing property and the capital gains tax gets deferred. However, if you exchange your way into a home you'd like to live in, move in for 2 years, then sell it and take the $500,000 exemption (if you're married) and repeat.
Oh, BTW, keep taking the deduction. I almost stopped as well because I feared the recapture, but if you use the 1031 exchange and homeowner's tax exemption effectively, you can avoid the tax.
Investor · Pawleys Island, SC · Member since 2008 · 1k+ posts · 837 votes
16y
Mitch,
Depreciation since May 1997 is always recaptured. Converting a rental to a primary residence before selling does not avoid the tax on unrecaptured depreciation.
Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
16y
Jon has it down! Seems everyone is ready for tax time, lol, but the only reason I jumped in is to suggest the OP to file an amended return since he didn't take the depreciation last year. You can go back three years and fix fould ups so long as you don't bring attention to the fact that you owe them (LOL)! So go back and fix it. Take the benefit, you're going to pay for it in the future as mentioned above....good luck, Bill
Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
16y
Originally posted by Mitch Kronowit:
Oh, BTW, keep taking the deduction. I almost stopped as well because I feared the recapture, but if you use the 1031 exchange and homeowner's tax exemption effectively, you can avoid the tax.
Note that depreciation recapture tax is computed on the depreciation taken or allowed, whichever is greater. You really MUST take the depreciation, even if you cannot use it to offset your ordinary income. You WILL pay depreciation recapture tax whether you took the deprecation or not. If you can't use it, it will become a carryforward passive loss that you can apply when you sell.
1031 exchanges don't avoid anything. They defer taxes. The only way to avoid taxes is to die. You can 1031 to your hearts content, but if you do eventually sell, you will owe the taxes. If you die, your heirs get the property with a stepped up basis based on the value at the time of your death, truly avoiding the taxes.
SFR Investor · Orange County, CA · Member since 2009 · 1k+ posts · 1k+ votes
16y
Originally posted by Jon Holdman:
1031 exchanges don't avoid anything. They defer taxes. The only way to avoid taxes is to die.
Well, THAT is the plan! We want to use the 1031 exchange to upgrade our way into our retirement home(s). We don't plan on selling them. They'll remain in a trust.
The Section 121 exemption still allows you to avoid capital gains tax on a primary residence that was once used as a rental AND acquired via a 1031 exchange, but it was weakened by the HOPE Act of 2008. So no, I guess you can't get off scott-free, but the longer you live in it, the more of the exemption you can take.
BTW, Dave T. is correct. The Section 121 exemption only applies to capital gains, not to depreciation recapture. Dang, I guess I'll never liquidate my RE holdings! :roll:
Investor · Pawleys Island, SC · Member since 2008 · 1k+ posts · 837 votes
15y
Originally posted by Mitch Kronowit:
The Section 121 exemption still allows you to avoid capital gains tax on a primary residence that was once used as a rental AND acquired via a 1031 exchange, but it was weakened by the HOPE Act of 2008. So no, I guess you can't get off scott-free, but the longer you live in it, the more of the exemption you can take.
Mitch,
There is a lot of misinformation in the financial press about the capital gains exclusion when a rental property is converted to a primary residence prior to sale. Marketwatch.com even got it wrong (at least their contributor got it wrong). At the time, I posted a comment to the article but I never saw an acknowledgement.
It is not the exclusion limit that changes, it is the amount of capital gain that can be excluded. For example, under the new tax rules, any period of rental use since Jan 1, 2009 is a period of "non-qualified" use for the capital gains exclusion. Only the capital gain allocated to periods of qualified use are eligible for the $250K/$500K Section 121 exclusion.
Whether the property was originally acquired in a 1031 exchange or simply purchased for investment rental use does not matter for this new tax rule.
Here is an example under the new rules. Let's say you and your spouse purchase a rental property on Jan 1, 2009 and use it as a rental for five years. At the end of five years of rental use, the two of you move into the property and use it as your primary residence for the next two years.
Just after completing two years of occuancy, you and your spouse sell your primary residence for a $350K profit due to appreciation. Since you are married and will file a joint tax return, the $500K capital gains exclusion limit applies.
Because you owned the property for seven years, but only used it as your primary residence for two years, only two of your seven years of ownership is a period of qualified use. Consequently, only 2/7 of your $350K capital gain due to appreciation, or $100K in this example, can be applied to the Section 121 exclusion.
SFR Investor · Orange County, CA · Member since 2009 · 1k+ posts · 1k+ votes
15y
Originally posted by Dave T:
Here is an example under the new rules. Let's say you and your spouse purchase a rental property on Jan 1, 2009 and use it as a rental for five years. At the end of five years of rental use, the two of you move into the property and use it as your primary residence for the next two years.
Just after completing two years of occuancy, you and your spouse sell your primary residence for a $350K profit due to appreciation. Since you are married and will file a joint tax return, the $500K capital gains exclusion limit applies.
Thanks for the info Dave, but what if you NEVER sell the property??? From what I can tell, CG taxes are paid after the SALE, not anytime before.