Decpreciation Recapture question

7 Replies

Hey everyone,

This is probably a basic question, but I couldn't find an answer on here.  I came across a seller who wants to sell her property, but she thinks that she can't sell for some reason.  She said that a CPA a few years back did something for 27 yrs, that is preventing her from selling, even though she would like to.  


This sounds like depreciation to me, so I imagine that they are telling her she'd have to pay tax for the depreciation recapture.  Is there anyway to avoid or limit this depreciation recapture?  Would buying it on owner financing and spreading the pymt out over a number of years impact when the depreciation recapture would be owed or how much would actually be owed?

I don't know if any of this is helpful or impacts the situation.  She does not have a mortgage.  I think she inherited the house, and she has been living there off and on for a period of time, but she says it was only the last 8 months that she's lived there.

Would the use of any entities - land trust, LLC, etc help? For example, if the current owner transfers the property to a land trust, and then I buy the beneficial interest of the land trust, instead of the actual home.

I feel like there should be a way to help this lady get out of the property, but she was told that she CAN'T sell the house by her current CPA.  Thanks in advance!

If it is depreciation recapture and she were to actually sell the property (without being willing herself to engage in a follow on 1031 exchange) then the depreciation recapture is going to be hard to escape. Even if she were willing to take back a note she would still need to pay tax on the depreciation recapture amount in the year of sale since that element of her gain is not eligible for installment reporting under those rules (although the remainder of gain might).

On the other hand, perhaps that is just an excuse for her to provide anyone who asks not to sell.

@Greg Martin , @Christopher Smith is correct. Outside of a 1031 exchange, she may have a hard time avoiding depreciation recapture. Depending on how long she's rented it out vs lived there in the past, she may be eligible for a 1031, and if she's looking to maintain an investment in real estate, that would probably be the smartest move anyway. 

Now, depending on what kind of stepped-up basis she got when she inherited the property, and how much it has appreciated since then - and IF she's lived there for at least 24 months out of the previous 60 months (the 2-out-of-5 rule) - then she might be able to take her gain on the property tax-free (up to $250k if she's single, $500k if married filing jointly) under the Section 121 exclusion. If she's had it as mixed-use (some rental, some self-occupancy) this exclusion may be pro-rated, so if she's not anxious to sell and she lives there currently, I'd recommend sitting tight for 16 months and then selling to exclude maximum gain. If the appreciation exceeds those exclusion limits, however, a 1031 is really the only way to avoid paying those taxes (for now) and she'd need to move out and establish it as a rental for the IRS to be cool with the exchange. It would be a bit more complicated (and I'd say she needs a new CPA because this one doesn't sound so great), but it is possible to combine the Sec 121 and Sec 1031 strategies for properties that have been used both as a rental and as a residence in the last five years.

Here's a good breakdown of what that would look like: http://www.exeter1031.com/article_overview_1031_12...

Another important point to make is that, even if she does avoid paying those taxes through a 1031, she would still owe them when she sells whatever new property she purchases through that exchange. Now, she could potentially avoid paying deprecation and CG taxes forever if she just kept doing 1031s, which is a legitimate and powerful strategy. Then, when she dies, whatever properties she's accumulated via these exchanges would pass to her heirs with a stepped-up tax basis equal to the current market value at the time of her death, which means the tax bill she'd been avoiding for years would just disappear and her heirs would have a tidy little inheritance - basically, if they wanted to, they could sell those inherited props for market value the day they inherit them and not pay a penny in taxes. It's not a DIY strategy by any means, but it's a popular and effective one.

So, she has some options, but if this is about depreciation recapture and not some other weird thing, her first move is to fire that CPA and get a new one. There are plenty of great pros here on BP, so if you're the charitable kind you could easily find some recommendations to pass along - or she could start her own account!

Best of luck!

Clayton

@Greg Martin , I think I know the post you are talking about and yes it was taxes in general and depreciation in particular that were killing her.

One point that was very astutely made is that depreciation recapture part of her gain could very well end up being miniscule since the depreciation schedule was set up in like 1970 or something like that.  So even for an owner carry situation where she would have to recapture same year it's probably not as much a game changer as her perception of it.

Hello All, 

I want to preface this by saying I am NOT an expert in 1031s by ANY means, but I always understand things better with examples, so I am going to try to do a ROUGH idea so those reading this get a clearer picture. Those of you who ARE experts PLEASE jump in if I am way off base :-)

I think what @Dave Foster is saying is this;

  • Lets assume the house was worth 50K when she got it, with 40K that could be depreciated (land can't be)
  • So she took 40K of depreciation over the 27.5 years to put her basis down to zero plus land. 
  • Fast forward to today - let's say it is worth 200K
  • If she sells on installments - land contract or what not, she CAN spread out her 150K of Capital Gain, but NOT her 'recapture'.
  • BUT, her recapture would only be 25% of the original 40K that she depreciated or 10K. Pretty minimal with all things considered. 

Hope that makes it a little clearer. There might be some in there for capital improvements that were depreciated too, but that is the general idea.

Dan Dietz

Originally posted by @Clayton Mobley :

@Greg Martin , @Christopher Smith is correct. 

Now, depending on what kind of stepped-up basis she got when she inherited the property, and how much it has appreciated since then - and IF she's lived there for at least 24 months out of the previous 60 months (the 2-out-of-5 rule) - then she might be able to take her gain on the property tax-free (up to $250k if she's single, $500k if married filing jointly) under the Section 121 exclusion. If she's had it as mixed-use (some rental, some self-occupancy) this exclusion may be pro-rated, so if she's not anxious to sell and she lives there currently, I'd recommend sitting tight for 16 months and then selling to exclude maximum gain. If the appreciation exceeds those exclusion limits, 

Clayton,  for a rental converted to primary residence before sale, it is the capital gain that is prorated.  The $250/$500K exclusion limits say intact.  

Example:  Buy a rental for $100K.  After five years of rental use and $15000 in depreciation, you convert the property to your primary residence for the next five years, then sell it for $150K.  You have owned the property for ten years, but it was your primary redience only 50% of the time.  Your capital gain due to unrecaptured depreciation is $15K.  Your capital gain due to appreciation is $50K (well under the §121 $250K/$500K exclusion limits), but only $25K (50%) qualifies for the §121 capital gain exclusion.  The unrecaptured depreciation is still taxed.

Thanks everyone for the info.  That was helpful, and we will see what we can do.  @Daniel Dietz & @Dave Foster that confirmed what I thought from reading other sites on the depreciation recapture, but I hadn't asked about what amount they depreciated.  I'm trying to get additional info, and we will see what happens.  Thanks again for your input!

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