Depreciation Recapture in Seller Financed Transaction
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.
Thank you in advance for your help.
Rob
@Kim B.@Roy N.@Bill Gulley@Brian Gibbons
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."
https://www.irs.gov/publications/p537/ar02.html#en...
Per IRS pub 544, Chapter 3:
"Installment SalesIf 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."
https://www.irs.gov/publications/p544/ch03.html#en...
So this is why it's always a good idea to get an opinion (or second opinion) from a qualified professional. Everyone makes mistakes.
Also, the Nolo article is extremely simplistic and not worth much. The author may have a J.D., but he's a professional writer and this article picked up none of the nuances of this topic. The CPA I spoke to said he did a return just yesterday with the installment sale of rental real estate, and the software handled it just as expected, deferring the depreciation.
I reviewed the TurboTax output to Forms 4797 and 6252 for one of the assets I sold, and it's doing the deferral perfectly. In fact, if you manually follow the logic on the forms, you can see that the software is doing it correct. I'm satisfied at this point. And the CPA on the other thread that was mentioned somewhere above concurred with this deferral as well.
Thanks for posting this David. The part that I found MOST interesting and helpful was this:
"...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."
If I understand this correctly, this could result in ordinary gain being taxed at a higher rate depending on the payment structure. For myself, I decided the best policy is making sure the down payment in a sale covers the recaptured depreciation amount. In my case, this worked with only 5% down.
@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 :)
Your response sparked and idea. I'm by no means a tax pro but, could depreciation recapture be deferred if the property was held in an LLC and a controlling interest in the LLC was purchased? This would make it an installment sale of a business correct? I'm interested in your response.
@David Beard is correct I believe based on this Forbes article and my reading of the code and instructions. I'll try to summarize.
If you sell a property, in most cases the accumulated depreciation is taxed at 25%.
Real estate is defined as 1231 and sub-defined as 1250. Under it's definition as 1250 you owe your higher ordinary income tax rate on "additional depreciation", meaning all depreciation you took above the straight-line method. Property aquired after 1986 must use the straight line method so generally there is no additional deprectiation and no ordinary income burden. That means all the depreciation you took is defined as "unrecaptured section 1250 gain". You can confirm this yourself by just reading the beginning of section 1250.
Okay, so now you have all of your depreciation as "unrecaptured section 1250 gain." This is a special type of gain, taxed up to 25%, and you can see this gain for an LLC on your 2015 Schedule K line 9.c and for your 1040 on Schedule D Line 19. If you look at the instructions for Schedule D Line 19 you see that you must fill out a "unrecaptured section 1250 gain worksheet." You can find that worksheet at the very end of the Schedule D instructions.
If you look at all the above forms and worksheets you will see exceptions if you had a loss etc. But generally you owe 25% of your "unrecaptured section 1250 gain" based on section 1 (h)(1)(E).
You can indeed use the installment method for these gains.
Look at the instructions for the "unrecaptured section 1250 gain" worksheet at the end of the 1040 Schedule D instructions. You will see that you have to first pay at the 25% rate until you have been paid (in installments) all of your "unrecaptured section 1250 gain" then you will pay at your normal capital gains rate as you receive further installments.
All of the above is of course about capital gains, interest will be taxed at ordinary income.