Rental Property Investor · Lake Oswego, OR · Member since 2015 · 22 posts · 2 votes
Hello All:
I am trying to purchase a 4-plex using seller financing and the Seller's accountant is telling the Seller that they need to receive enough of a down payment to cover the depreciation recapture which is taxable in the year of the sale. Is this true? I have never heard of this. Is there a way for the seller to somehow defer that tax?
For reference, the terms of the transaction are: $0 down and monthly interest only payments at 6% with the balance due in 7 years.
Unfortunately, Nathaniel is incorrect in stating that "normal" straight line depreciation is not subject to recapture in the year of the sale. He further cites that "normal" depreciation does not stem from Section 1245 or Section 1250 property. Let me try to explain and correct the thinking:
Section 1245 property can generally be thought of as personal property. Section 1250 property is defined as "depreciable real property that is not Section 1245 property." A rental property therefore falls under the Section 1250 definition since it is depreciable real property, but not considered personal property.
Section 1250 property is subject to depreciation recapture at a rate of 25%. This recapture is ALWAYS due in the year of the sale, regardless of how the sale is structured. Realized gain in excess of depreciation recapture is treated as capital gain. This excess gain will be subject to installment sale rules, meaning it can be spread out over the life of the loan.
Per IRS publication 537 - Installment Sales:
"Depreciation Recapture Income
If you sell property for which you claimed or could have claimed a depreciation deduction, you must report any depreciation recapture income in the year of sale, whether or not an installment payment was received that year. Figure your depreciation recapture income (including the section 179 deduction and the section 179A deduction recapture) in Part III of Form 4797. Report the recapture income in Part II of Form 4797 as ordinary income in the year of sale. The recapture income is also included in Part I of Form 6252. However, the gain equal to the recapture income is reported in full in the year of the sale. Only the gain greater than the recapture income is reported on the installment method. For more information on depreciation recapture, see chapter 3 in Publication 544."
If you report the sale of property under the installment method, any depreciation recapture under section 1245 or 1250 is taxable as ordinary income in the year of sale. This applies even if no payments are received in that year. If the gain is more than the depreciation recapture income, report the rest of the gain using the rules of the installment method. For this purpose, include the recapture income in your installment sale basis to determine your gross profit on the installment sale.
If you dispose of more than one asset in a single transaction, you must figure the gain on each asset separately so that it may be properly reported. To do this, allocate the selling price and the payments you receive in the year of sale to each asset. Report any depreciation recapture income in the year of sale before using the installment method for any remaining gain."
In Canada, that is the way it would play out and, I believe, it is the same in the U.S.A (Steve Hamilton will know). The capital cost allowance (aka depreciation) recapture is due in the year of sale. The fact the seller is becoming the mortgagee is a separate matter altogether - though in both Canada and the U.S.A., it affords the seller the ability to defer capital gains over several years.
@Robert McEachern depreciation recapture will be due in the year of the sale, even if seller financed. The buyer will need to figure the total amount of depreciation the subject property has incurred over the hold period and multiply the value by a 25% tax rate.
@Brandon Hall@Roy N. Thank you both for your insights. Just to make sure I'm understanding correctly, if there is $100,000 of depreciation recapture, the Seller owes $25,000 in federal taxes the year of the sale. Is it taxed on the state level?? Will that be in addition to the 25%?
Depreciation recapture occurs only on in the event of a sale. Structure this thing as a master lease with an option whenever. Since you're not planning on including principle into the debt service, there are no further issues.
Now - the IRS gets screwy and wants to consider a 5 year master lease as an installment sale some times. Get a good attorney, and talk to a good CPA who's been dealing with this stuff for 20 years.
Even with a master lease and option, the Lessor/Vendor will be expecting an end-game which results in a sale and the Tax Man will still be there with his hand out. You might be able to reduce the amount of recapture through capital investment (but these would be lease-hold improvements and may not be attributable to the Vendor/Lessor's tax situation).
Up here (Canada), you would be all but guaranteed the CRA would flag it as an instalment sale.
@Roy N. - if nothing else is done, then yes - when the option is exercised the depreciation has to be recaptured. Unless, some other creative solutions are applied which may off-set. I am not an expert, but there may be ways :)
Besides, the seller wants enough down to cover recapture. The OP can save the CF over 3-5 years and excersize by converting from lease option to installment sale when he has enough DP. If the seller is willing to do installments of interest only, he is looking for an annuity. There are ways :)
Thank you all for your commentary. Are there any other taxes that would be due in the year of the sale in this situation? I'm trying to figure out how much I need to come to closing with to cover all of the Seller's costs (closing costs, taxes, etc.).
Thank you all for your commentary. Are there any other taxes that would be due in the year of the sale in this situation? I'm trying to figure out how much I need to come to closing with to cover all of the Seller's costs (closing costs, taxes, etc.).
Thank you in advance.
Rob
That does sum it up. You will need to cover recapture AND state tax. Keep that in mind. There could be other issues as part of that downpayment will be allocated to capital gain as well which could be as high as 23.8% plus state rates.
This may be too late for the OP, but there seems to be disagreement about whether normal, straight line depreciation must be recaptured in the first year. See Nathaniel Busch's second comment in this conversation:
I'll leave it to Steve Hamilton and Brandon to field that comment about straight line depreciation being eligible for recapture by instalment in the U.S.A.
In Canada, the recapture of depreciation - called Capital Cost Allowance (CCA) by the taxman - is due in the year of sale.
@Robert McEachern depreciation recapture will be due in the year of the sale, even if seller financed. The buyer will need to figure the total amount of depreciation the subject property has incurred over the hold period and multiply the value by a 25% tax rate.
Hope this helps!
And, that is to determine the taxable gain, is the amount payable, tax due, however under an installment sale, seller financing with equity financed being an installment sale, is it not still calculated to the % of principal as it is received together with interest income? In the above $100,000 example, 25% would be split from principal payments.
If not, that blows a huge hole in seller financing, now I'm not speaking as to options, if you can point us in the direction for that, that would/could be a very big deal. :)
Unfortunately, Nathaniel is incorrect in stating that "normal" straight line depreciation is not subject to recapture in the year of the sale. He further cites that "normal" depreciation does not stem from Section 1245 or Section 1250 property. Let me try to explain and correct the thinking:
Section 1245 property can generally be thought of as personal property. Section 1250 property is defined as "depreciable real property that is not Section 1245 property." A rental property therefore falls under the Section 1250 definition since it is depreciable real property, but not considered personal property.
Section 1250 property is subject to depreciation recapture at a rate of 25%. This recapture is ALWAYS due in the year of the sale, regardless of how the sale is structured. Realized gain in excess of depreciation recapture is treated as capital gain. This excess gain will be subject to installment sale rules, meaning it can be spread out over the life of the loan.
Per IRS publication 537 - Installment Sales:
"Depreciation Recapture Income
If you sell property for which you claimed or could have claimed a depreciation deduction, you must report any depreciation recapture income in the year of sale, whether or not an installment payment was received that year. Figure your depreciation recapture income (including the section 179 deduction and the section 179A deduction recapture) in Part III of Form 4797. Report the recapture income in Part II of Form 4797 as ordinary income in the year of sale. The recapture income is also included in Part I of Form 6252. However, the gain equal to the recapture income is reported in full in the year of the sale. Only the gain greater than the recapture income is reported on the installment method. For more information on depreciation recapture, see chapter 3 in Publication 544."
If you report the sale of property under the installment method, any depreciation recapture under section 1245 or 1250 is taxable as ordinary income in the year of sale. This applies even if no payments are received in that year. If the gain is more than the depreciation recapture income, report the rest of the gain using the rules of the installment method. For this purpose, include the recapture income in your installment sale basis to determine your gross profit on the installment sale.
If you dispose of more than one asset in a single transaction, you must figure the gain on each asset separately so that it may be properly reported. To do this, allocate the selling price and the payments you receive in the year of sale to each asset. Report any depreciation recapture income in the year of sale before using the installment method for any remaining gain."
@Brandon Hall My CPA was down the hall from me and that's why I didn't or do taxes, just wrote the check, and yes, that rang a bell after reading that excellent post. Thanks for the details! :)
This may be too late for the OP, but there seems to be disagreement about whether normal, straight line depreciation must be recaptured in the first year. See Nathaniel Busch's second comment in this conversation:
Brandon covered that perfectly; however, if sold in the first year you do not have to take the depreciation. This is one of the great reasons for Cost Segregation though if you're a high earner. (250k plus)
@Brandon Hall, I just had a CPA/tax attorney tell me that for Section 1250 property (real estate) that was amortized straight line (as essentially all investment real estate has been for many years), the accumulated depreciation is not characterized as "recapture income" at time of sale, but as "capital gains" with a special rate (up to 25% vs 15% cap gains rate). Since it's capital gains, he says that it CAN be deferred in an installment sale. Refer to IRC section 453 for definition and use of term "recapture income". Please refer to Pub. 537, section titled "Example -- Sale of a Business" and look how the sale of the Building (Sec 1250 property) is being handled in an installment sale, for confirmation in an IRS example.
I received a second confirming opinion from another CPA that the accumulated depreciation is eligible for deferral under an installment sale. As a minor additional point, I was told that as gains are recognized in current and future periods, the total amount will be taxed at the 25% rate until all prior depreciation has been recognized/exhausted... and then the remaining gains will be taxed at the normal 15% cap gains tax rate.
The CPA/tax attorney also demonstrated that his tax software does the full deferral of the accumulated depreciation in the manner in which he described.
There is much confusion and misinformation on-line (including here on BP), which is surprising give how common it is to sell rental real estate property with seller financing. One would think It would be unambiguous.
Interested to hear further comments from CPA's, EA's, or other tax pros. Seems like an area where real estate investors need to have a clear understanding.
As a final test, I ran an example through TurboTax Business 2015, and the program did in fact defer the ENTIRE gain, including accumulated depreciation... @Steven Hamilton II, @Kim B., @Robert McEachern, wanted you to see this information, thanks.
In reading your posts, I am not entirely clear (different tax system), but is the treatment you describe only applicable to an instalment sale (where the sale is only complete once all instalments have been paid)? It appears you are being taxed annually on the portion of the sale that completes during that year?
Conversely, with a Vendor carry {property is sold, but vendor becomes the lender (or a lender) subscribing to a mortgage on the property} the sale occurs up-front. Would not the full depreciation recapture be due in the year of sale?
@David Beard your CPA/real estate attorney is getting confused with selling a business vs rental real estate. It seems like Turbo Tax is as well.
When you sell rental real estate, Sec 1250 property, the entire depreciation recapture is due in the year of the same regardless of whether or not the installment method is used. This is supported by Sec 453(i)(1) and Pub 537 (see Depreciation Recapture Income paragraph).
When you sell a business (inventory, equipment, accounts receivable/payables, intangibles, buildings), you play by different rules.
Three paragraphs above the example you cited, we have this paragraph:
"Sale of a Business
The installment sale of an entire business for one overall price under a single contract is not the sale of a single asset."
Because I don't have time to go into further detail (tax season!), read this NOLO post (written by a tax attorney).
Also keep in mind - just because someone is a tax attorney doesn't mean they didn't stumble through their education and research. What do you call a med student that graduated with all C's? A doctor :)
@Brandon Hall, the CPA is not confused about rental real estate vs business real estate. He made no distinction. I actually used the example of the business sale in which one of the underlying assets is Sec 1250 real estate. The treatment of the real estate (even though owned by a business) is no different than rental real estate owned by an individual or an partnership. If you think so, please cite your support.
I've reviewed his research straight from the IRC and it all hangs together. Your citations of IRS publications seem to me to be not fully in context. Your research refers only to "depreciation recapture income" being treated in such-and-such a way, and the point is that Sec 1250 straight-line depreciation IS NOT "depreciation recapture income" at all, so any references to "depreciation recapture income" do not apply. It is in fact capital gains, albeit a special type of gain subject to a special rate. Thus your citations do not apply. Both the CPA's professional software, as well as Turbotax, agree.
You reference Section 453(i)(1), which is fine, but then 453(i)(2) has the definition for "recapture income", basically saying that it's only the portion of depreciation treated as ordinary income, and Section 1250 straight-line depreciation is NOT ordinary income, it's capital gains (technically called "unrecaptured section 1250 gain"). Please refer to the next section for support of what depreciation is treated as ordinary income (in short, straight line depreciation on Sec 1250 real estate is not ordinary income).
Quoting from IRS Pub 544:
Section 1250 Property
Gain on the disposition of section 1250 property is treated as ordinary income to the extent of additional depreciation allowed or allowable on the property. To determine the additional depreciation on section 1250 property, see Additional Depreciation, below.
Section 1250 property defined. This includes all real property that is subject to an allowance for depreciation and that is not and never has been section 1245 property. It includes a leasehold of land or section 1250 property subject to an allowance for depreciation.
Additional Depreciation
If you hold section 1250 property longer than 1 year, the additional depreciation is the actual depreciation adjustments that are more than the depreciation figured using the straight line method. For the treatment of unrecaptured section 1250 gain, see Capital Gains Tax Rate, later.
@Brandon Hall Brandon, sorry for sounding rude and/or brusque. I'm in a hurry and frustrated. I sold 10 properties last year with seller financing in gain position. I've got two CPAs and two software packages telling me that I can defer taxes on most of the unrecaptured 1250 depr. gain (defer on all but the down payment and small principal received last year) , and I'm anxious to resolve before Monday, needless to say ... very much appreciate your taking a moment during an incredibly busy seasonal time...