Depreciation Recapture (and Condo Converting)

2 Replies

Hi Guys,

So I am trying to (finally) figure out the truly correct way to calculate my taxes on an underperforming 2-family property I'm going to sell soon (for purposes of below, I plan to sell in June 2015 and have estimated applicable numbers thru then). So here are a few ballpark numbers:

1) Initial Cost Basis (Purchase + Closing Costs): ~$677k (2008)

2) Total Depreciation Taken (2008 thru June): ~$166k

3) 25% Tax on Depreciation: $41,450

4) Cost Basis + Depreciation: ~$843k (#1 + #2)

5) Estimated Net Sales Price (as-is): between $650 and $725k

6) Estimated Net Sales Price (Condo Conversion): between $725k and $825k

7) Existing Mortgage (as of June): ~$424k

8) Potential Proceeds (as-is): between $226k and $301k (#5 minus #7)

9) Potential Proceeds (Condo Conversion): between $301k and $401k (#6 minus #7)

Now, for my TAX question:

1) Am I figuring out my taxes the right way by saying:

a. My tax liability for depreciation recapture will be $41,450 (the 25% tax on Depreciation Taken); and then

b. I will show a paper/passive loss on the property because Cost Basis + Depreciation equals $843k, but will not have net proceeds for that amount (so my net loss will depend on the sales price)?

c. Or is the way I have figured it in #b above (Cost Basis + Depreciation or #3 above) NOT the right way to figure out the Total Cost Basis...is it just the actual Cost Basis (#1 above) minus the Net Proceeds?

And now for my CONDO CONVERSION question:

1) I was just informed by my lawyer that if I do a condo conversion, then any gain from the sale is automatically taxed as ordinary income, regardless of how long I held it (because the IRS views the intent as a "flip"). So in this situation, assuming the way I figured out my taxes in 1a & 1b above are correct, it won't really matter since I am showing a loss either way, correct? Or if #1c above is the correct way to figure out the gain, then might I be liable for ordinary income on this property if I do a condo conversion, vs. long term capital gain if I sell it as-is as a rental property?

sorry for the long question. thanks all

Hi John,

Your total cost basis is not determined by adding the depreciation taken to  the original  cost.  The original cost is your total or original cost basis.  The original cost basis less your depreciation recapture is your current adjusted cost basis.  The adjusted cost basis is the number that is used to compute your total taxable gain, which is then broken down into capital gain and depreciation recapture. 

What your attorney said about condo conversions is true ONLY IF you convert and then  intend to sell.  If you convert and then intend to hold as rental properties, then your intent is not to flip but to hold for investment purposes and then the tax consequences would be completely different, including your ability to complete a 1031 Exchange at that point.

Hi Bill-thanks so much for the quick reply.  So can I get a little more clarification, because this is precisely the point that I have heard from differnt CPA's that confuses me!  And just to keep it simple, let's use the numbers in my example.  So you're saying that my taxable gain is: 

Original cost basis ($677k) - Depreciation Recapture ($166k) = Adjusted cost Basis ($511k)

and then

Net Selling Price (let's just say $700k) - Adjusted Cost Basis ($511k) =  Taxable Gain ($189k)

So then what part of that $189k do I apply the long term capital gains rate (20% + 3.9% + state/local) to vs. what I apply the Depreciation Recapture Tax (25%) to?  

This is where my point of confusion is:  there are two different rates (25% for depreciation recapture and whatever your tax rate is for LTCG).  

And thanks for the clarification re. the Condo Conversion.  I do have the intenion to convert and sell right away (and the whole reason this came up is because I was trying to weigh the merits of a 1031).  Thanks Bill.  

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