recaptured depreciation is killing me! accountant help

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recaptured depreciation is killing me! accountant help

Alan Brown
Rental Property Investor · NY MA CT VT MT, MO · Member since 2015 · 200 posts · 116 votes

Hi I'm pretty sure I'm an idiot, but I'm getting slapped hard for it (again!)... I always thought that depreciating your property (and getting a tax write off for it) was permanent... So, a few years ago when I had a 1031 falling through, and my accountant said I'd owe $90k in taxes because of the recapture and the gain, of course we MADE the 1031 HAPPEN!  

So I just sold a property this last summer and I calculated that my sales cost, less sales costs, minus adjusted basis, was my taxable gain... about $35k in gain.  We needed the cash, so I decided to take the hit on $35k... not $113k!!!  

So now we owe $22k in taxes.... because of the recapture after 14 years of depreciation...aaagh!  

I could swear I'd heard it on some real estate podcast (of course not BP) or something, that one of the great things about real estate investing was that you could depreciate your property, and even if you had a gain on the property, you didn't have to pay that back.  I guess all the properties I've sold for myself, I've either done a 1031 or sold it after just a few years, thus not paying much attention to a minimal amount of recaaaaapture.

I wish someone would tell me, 'NO you're right!  depreciation just goes away'    anybody ok with lying to me?  might make me feel better for a little while till I get the checkbook out.

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Natalie KolodijBusiness Member
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Tax Strategist| National Tax Educator| Accepting New Clients · Member since 2014 · 3k+ posts · 4k+ votes
9y

It's important to note too...

That the IRS makes you recapture depreciation even if you didn't take it. That's your fault for missing that deduction. So it's not something you have a choice in. Just...fyi. 

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  • JD MartinBusiness Member
    Moderator
    Rock Star Extraordinaire · Northeast, TN · Member since 2015 · 10k+ posts · 16k+ votes
    9y

    The concept of depreciation is that the item has no monetary value at the end of the schedule. If you sell the item for a profit, unless you can redirect those profits legally, I don't think there's any way out of paying the taxes. 

    It's really a pretty good deal, even with the tax bite. Without the depreciation, you would have owed that level of taxes on that income all those years. If, per chance, the property really was worthless at the end of the schedule, you would have lost the tax advantages for all that time. 

    I'd lie to you, but I'm not really a very good liar :D

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  • Alan Brown
    OP
    Rental Property Investor · NY MA CT VT MT, MO · Member since 2015 · 200 posts · 116 votes
    9y

    So I just have to always plan on doing a 1031 exchange... 

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  • Steven Hamilton IIPro Member
    Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
    9y

    Sorry,

    I don't have any good news for you. 

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  • Andrew Johnson
    Real Estate Investor · Encinitas, CA · Member since 2016 · 3k+ posts · 3k+ votes
    9y

    @Alan Brown The real fun part is the "value" of depreciation changes based on your tax bracket. If you're in that 39.6% federal tax bracket getting to write off depreciation is much more advantageous than if you're in the 15% tax bracket (isn't marginal ordinary income fun?). At least your post is bringing to light what most new investors don't think about: deprecation recapture. It's also why 1031s are popular as is passing property to along to your heirs as when you die the FMV resets. Isn't it fun how tax codes impact how people invest? :-)

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  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    9y

    @Alan Brown, The govt never giveth without being able to take away.  If you're an investor that holds property long enough for significant depreciation to build up then yes you should be taking advantage of the 1031 on that part of your investing.  Depreciation is a temporary faux tax break that they'll get back eventually unless you use the 1031 and estate/retirement planning to position it to not impact you in your lifetime.  

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  • Alan Brown
    OP
    Rental Property Investor · NY MA CT VT MT, MO · Member since 2015 · 200 posts · 116 votes
    9y

    nobody will lie to me...:(

    3Reply
  • Russell BrazilBusiness Member
    Moderator
    Real Estate Agent · Washington, D.C. · Member since 2012 · 17k+ posts · 30k+ votes
    9y

    I actually don't like depreciation because of the recapture. I've said numerous times that if I had a choice, i would choose not to depreciate my property.  I feel like depreciation forces me into either selling a property early before too much depreciation occurs or forces me into a 1031 if I've held it for a long time.

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  • Paul Allen
    Financial Advisor · Virginia Beach, VA · Member since 2017 · 502 posts · 508 votes
    9y

    If the government offered to let you borrow $$$ now and pay it back 14 years later without interest, would you?

    Because you did.

    There's a difference between getting a bad deal and not getting as good a deal as you thought you were getting. :)

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  • Paul Allen
    Financial Advisor · Virginia Beach, VA · Member since 2017 · 502 posts · 508 votes
    9y

    @Russell Brazil

    Technically you don't have to take depreciation. However, the allowable depreciation you declined to take would still be used to adjust the basis of your property and you'd pay capital gains taxes on the amount of depreciation you declined to take - without any current year tax benefits to offset it. This puts you in a significantly worse tax situation than taking your depreciation deduction, but it's *possible*.

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  • Joel OwensBusiness Member
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    Real Estate Broker · Canton, GA · Member since 2010 · 15k+ posts · 11k+ votes
    9y

    Some people do a 1031 exchange and then a few months later do a cash out refinance after the purchase and pull money out that way. 

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  • Mike Dymski
    Investor · Greenville, SC · Member since 2016 · 5k+ posts · 13k+ votes
    9y

    Refinance rather than sell to get cash out...that's likely what you heard.

    Take the pre-tax amount of the recapture, calculate the earnings you made on it over 14 years, include the time value of money and that amount should cover the taxes many times over.  Deferred taxes are a good kind of slap.

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  • Natalie KolodijBusiness Member
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    Tax Strategist| National Tax Educator| Accepting New Clients · Member since 2014 · 3k+ posts · 4k+ votes
    9y

    It's important to note too...

    That the IRS makes you recapture depreciation even if you didn't take it. That's your fault for missing that deduction. So it's not something you have a choice in. Just...fyi. 

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  • Alan Brown
    OP
    Rental Property Investor · NY MA CT VT MT, MO · Member since 2015 · 200 posts · 116 votes
    9y

    @Joel Owens, yes, I have a 1031 coming up, and that's exactly what I think I will do now!  Excellent point.  I need to be done with that particular market, and now's the time to sell it, so here we go.  As much as I appreciate the 1031 and have used the crap out of it (Canadians, poor happy souls, have no such lovely thing), I do wish it's 45 day window and property identification were not so arbitrary... 

    I'm whining of course, but the last one I did, the Seller knew that after the 45 days I had no other properties that would work (top end limit of $ amount of properties I could identify was maxed), so he had all the leverage, and screwed me on some major inspection Items that came up.  Rehabs were nowhere near done at the end of my 45 days, so he got away with about $20k in work I could sue him for, but that won't happen of course.  Anyway, I did get some great properties out of it and avoided a $90k tax & recapture hit!

    @Russell Brazil,  THANK YOU for saying that!!  As much as I know I'm paying a lesser tax rate on that money in the end result than regular income, I kind of wish I could just not have the write off for depreciation, so I was not forced into the 1031.   Just pay the 18% on my gain at the end and be done with it!  

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  • Paul Allen
    Financial Advisor · Virginia Beach, VA · Member since 2017 · 502 posts · 508 votes
    9y

    @Natalie Kolodij

    Not 100% true, strictly speaking.

    per section 1250(b)(3):

    ... if the taxpayer can establish by adequate records or other sufficient evidence that the amount allowed as a deduction for any period was less than the amount allowable, the amount taken into account for such period shall be the amount allowed...

    HOWEVER, as I mentioned above, (per section 1016(a)(2)) you adjust the basis by the allowable depreciation - which means you would have to pay capital gains on the value of the allowable depreciation without ever having taken a deduction for the depreciation.

    Taxes are easy.  :-0

    1Reply
  • Natalie KolodijBusiness Member
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    Tax Strategist| National Tax Educator| Accepting New Clients · Member since 2014 · 3k+ posts · 4k+ votes
    9y

    Hi Paul, 

    Given, I haven't been in tax for decades but I've never come into a situation where the allowed/allowable didn't generally override. 


    Can you please explain how a tax payer would establish that the amount allowed was less than the  amount allowable? 

    @Steven Hamilton II Have you come across this?  I'd love to get a better understanding on this topic 

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  • Linda WeygantPro Member
    Investor and CPA · Arvada, CO · Member since 2015 · 2k+ posts · 3k+ votes
    9y
    Originally posted by @Natalie Kolodij:

    Hi Paul, 

    Given, I haven't been in tax for decades but I've never come into a situation where the allowed/allowable didn't generally override. 


    Can you please explain how a tax payer would establish that the amount allowed was less than the  amount allowable? 

    @Steven Hamilton II Have you come across this?  I'd love to get a better understanding on this topic 

     I'd love to know this too.  

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  • Natalie KolodijBusiness Member
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    Tax Strategist| National Tax Educator| Accepting New Clients · Member since 2014 · 3k+ posts · 4k+ votes
    9y
    Originally posted by @Linda Weygant:
    Originally posted by @Natalie Kolodij:

    Hi Paul, 

    Given, I haven't been in tax for decades but I've never come into a situation where the allowed/allowable didn't generally override. 


    Can you please explain how a tax payer would establish that the amount allowed was less than the  amount allowable? 

    @Steven Hamilton II Have you come across this?  I'd love to get a better understanding on this topic 

     I'd love to know this too.  

     Man I'm glad this wasn't just me haha  But hey, ya don't know what ya don't know so I'm open to learning !

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  • Linda WeygantPro Member
    Investor and CPA · Arvada, CO · Member since 2015 · 2k+ posts · 3k+ votes
    9y
    Originally posted by @Natalie Kolodij:
    Originally posted by @Linda Weygant:
    Originally posted by @Natalie Kolodij:

    Hi Paul, 

    Given, I haven't been in tax for decades but I've never come into a situation where the allowed/allowable didn't generally override. 


    Can you please explain how a tax payer would establish that the amount allowed was less than the  amount allowable? 

    @Steven Hamilton II Have you come across this?  I'd love to get a better understanding on this topic 

     I'd love to know this too.  

     Man I'm glad this wasn't just me haha  But hey, ya don't know what ya don't know so I'm open to learning !

     Agreed.  Just because I've been doing taxes for 20 years doesn't mean I know or have seen it all.  Steven does a much larger volume of tax returns than I do, so I'd love his insight into this.

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  • David Zheng
    Investor · Saint Louis, MO · Member since 2016 · 970 posts · 1k+ votes
    9y

    Good news!! everyone here is lying to you. I believe based on my calculations you are actually OWED 22k! Take it to the IRS and demand it. Usually if you do it within a couple weeks of receiving your tax status, you get a bonus unicorn!

    4Reply
  • Steven Hamilton IIPro Member
    Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
    9y
    Originally posted by @Natalie Kolodij:

    Hi Paul, 

    Given, I haven't been in tax for decades but I've never come into a situation where the allowed/allowable didn't generally override. 


    Can you please explain how a tax payer would establish that the amount allowed was less than the  amount allowable? 

    @Steven Hamilton II Have you come across this?  I'd love to get a better understanding on this topic 

    Technically this is only half correct; however, you have to not just take into context the one line but the entire tax code.  I will tell you what will happen a basis reduction doesn't just happen and to do so would be a major disservice to your client. What you SHOULD do is Form 3115 to take the unclaimed depreciation as a section 481 adjustment and then you would recapture at the maximum rates. 

    The burden of proof is on the taxpayer to prove that the deduction allowed would be minute if any and the IRS will allocate to the structure.. I wouldn't waste my time as recapture is still required on the amount allowable. Good luck proving that none was allowed.  It is simply not going to happen.  Recapture is not a bad thing. Passive losses aren't either.

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  • Paul Allen
    Financial Advisor · Virginia Beach, VA · Member since 2017 · 502 posts · 508 votes
    9y

    If you took $0 depreciation on your tax return that would be adequate records that the amount allowed was less than the amount allowable.

    I am splitting hairs, of course, and probably shouldn't on a RE forum. But strictly speaking you don't have to take the depreciation. You just have to take the depreciation adjustment to basis. (In which case it would be recovered at CG rates and not unrecaptured section 1250 gain rates.)

    This is not a viable tax strategy, mind you. I'm not recommending it. I'm just pointing out that it is technically possible. 

    [/taxnerdstuff]

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  • Steven Hamilton IIPro Member
    Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
    9y
    Originally posted by @Paul Allen:

    If you took $0 depreciation on your tax return that would be adequate records that the amount allowed was less than the amount allowable.

    I am splitting hairs, of course, and probably shouldn't on a RE forum. But strictly speaking you don't have to take the depreciation. You just have to take the depreciation adjustment to basis. (In which case it would be recovered at CG rates and not unrecaptured section 1250 gain rates.)

    This is not a viable tax strategy, mind you. I'm not recommending it. I'm just pointing out that it is technically possible. 

    [/taxnerdstuff]

    You are wrong. That is not how it works. That is NOT an adequate record and you should not even suggest it as any taxpayer that followed that advice would be raked over the coals to say the least.

    I pray no one is stupid enough to walk into an audit alone. I just picked up another Rep case that I'm resolving for another EA. 

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  • Steven Hamilton IIPro Member
    Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
    9y

    I have to get back to the 107 returns I have in my WIP. Good luck.

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  • Slava Okunev
    Hallandale, FL · Member since 2016 · 7 posts · 1 vote
    9y

    Good day,

    Does this depreciation on taxes killing DTI (debt to income) ratio? Or banks just look at rental income without depreciation?

    Thank you all and have a good day!

    0Reply
  • Paul Allen
    Financial Advisor · Virginia Beach, VA · Member since 2017 · 502 posts · 508 votes
    9y

    @Steven Hamilton II

    I'm not sure I could have made it any clearer, IT'S NOT ADVICE.

    It's just possible. (Like having $50K in schedule A deductions, but taking the standard deduction anyway, is possible.  Dumb, but possible.)

    But you are correct about this - I should not have brought it up.  :-)

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