Deprecation recapture on roofs and other improvements

Tax, SDIRAs & Cost Segregation
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Deprecation recapture on roofs and other improvements

Mark Patel
Investor · Missouri City, TX · Member since 2014 · 9 posts · 1 vote

I have a question on deprecation recapture and the tax consequence.  When you depreciate a expense like a roof then sell the property.  It seems that the roof expense become a capital gain since you have to add the depreciation recapture back in to the cost bases.   

 The best way to ask it is to provide a made up scenario to highlight the point above. 

Baseline assumptions for this example:

-Investment single family home is purchased for $100k in year 1 and sold for $100K in year 10

-The home was 100% rent ready on the day of closing (no rehab needed) except for 1 item that is listed below. The tenant moved in on day 1 and stayed for 10 years.

-The home is depreciated at $1k per year or $10K deprecation over the 10 year of ownership. This amount is just for example purposes for easier math.

-The rental property made Zero dollars each year in profit. The rental income and expenses were equal and on the tax return the net effect is the depreciation loss that is taken each year.

-Upon sale in year 10 there is no 1031 exchange and the owner will pay capital gain tax if any.

- You can not offset real estate loss from you regular W2 income for the 10 years due to tax rules (you make too much in W2 income, not real estate professional, etc etc)

Scenario #1

After purchasing the rental home the roof was replaced at $5K. The $5K was written off as an expense for that year. Again this is just an example as this could be a $5K roof or a $500 stove etc. Since the assumption is that in all 10 years the property makes $0 dollars profit then this $5k is written off and is carried forward year over year until there is a profit or property is sold

Scenario #2

After purchasing the rental home the roof was replaced for $5K. The $5K was depreciated over 10 years or $500 / yr on the tax return. Again the numbers are just an example to make the math easier and the actual deprecation length of 10 years is just for easy math in this case.

Question:

In year 10 when the property is sold what is the cost bases and what is the capital gain that will be taxed when filing the tax return for both scenario above? Below is my analysis and need to understand where I might be incorrect:

Scenario #1: $100K purchase - $5K expense that has been carried forward year after year + $10k home depreciation recapture - $100 sale price = $5k in capital gain in year 10 upon sale of the property.

Scenario #2: $100K purchase + $10K deprecation + $5K roof deprecation recapture - $100K sales price = $15K in capital gain in year 10 upon sale of the property.

Thanks

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  • Paul Caputo
    Cost Segregation Specialist · Naperville, IL · Member since 2016 · 204 posts · 168 votes
    9y

    You can't expense out a roof, so scenario #1 doesn't work. De minimis safe harbor rules say you can expense out items up to $2500. When something is expensed out it's not put on the depreciation schedule since it isn't being depreciated. You get to fully deduct that expense in the current year and it is not recaptured. If you just did repairs that can be expensed, but depreciable assets must be depreciated according to the class life set in MACRS. It'd be 27.5 years on a roof in a rental property. Also you must keep in mind that the depreciable cost basis is the improvement value (the building and any improvements to the property) and the land value is non depreciable. 

    If you really want to know what the rules are for rental properties read IRS Publication 527: Residential Rental Property It's only 24 pages and goes over all the tax code that applies to rentals. 

    Depreciation will be recaptured at a maximum of 25% so $10,000 in depreciation would have a tax bill of $2,500 upon sale of the property assuming you are at or above the 25% marginal tax rate. Recapture is based on depreciation taken or allowable, usually whichever is more. 

    So in your scenario the reality would be something like this: $120K purchase with $100K improvement value and $20K land value. $100K is the initial depreciable cost basis. You replace the roof for $5K so now your adjusted cost basis is $105K at the beginning. Since it's 27.5 year asset lives for rental property after 10 years you've depreciated 10/27.5 = 36.36%. So take the adjusted cost basis from the beginning $105K x 36.36% = $38,181.81 depreciation taken in years 1-10. Your new adjusted cost basis after 10 years would be $105K - $38,181.81 = $66,818.19. So you've been getting a $3,818.18 tax deduction from the depreciation each year for 10 years. When you sell the property the depreciation is recaptured at 25% so you're looking at $38,181.81 x 25% = $9,545.45 depreciation recapture tax. If you sell the property for $125K (Original value = $100K improvement + $20K land + $5K roof) there would be no further capital gains taxes. If you sold it for $130K you would have $5K of capital gains taxed at 15% = $750 capital gains tax. If you sold it for $120K you'd have $5K in capital losses which would be disallowed and carry forward into the next tax year unless you had other capital gains to offset the losses. You could subsequently get $5K in capital gains tax free by the offset. 

    Hope this helps clear up some of your questions. I'm sure you've heard this before, but it's a good idea to talk to a CPA that knows real estate to figure out all the tax stuff in the best way.

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  • Mark Patel
    OP
    Investor · Missouri City, TX · Member since 2014 · 9 posts · 1 vote
    9y

    Thanks for your detail reply.  I believe I understand the tax implication of depreciating a expense like roof.  The key point you made was that the adjusted cost basis was increased to include the roof expense.  I was not sure if that was the correct process.  If you dont include the roof expense in your cost basis then the roof replacement cost would be counted as a gain upon sale.   

    Thanks

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