This post was contributed by my friend Forrest Baumhover, a Certified Financial Planner® with Lawrence Financial Planning. This is tricky stuff – hearing it explained different ways can make it easier to understand. I’ve written about the same subject at Understanding Depreciation Recapture Taxes on Rental Property.
Just because you joined the military, you shouldn’t have to give up the right to buy a house. While there are many things to consider, you may:
- Buy a starter home
- Purchase a home that you plan to live in, fix up, and sell for profit
- Buy a home that you plan to live in after leaving the military
Whatever the reason, things don’t always work out as planned. When that happens, many military people become . This article looks at one of the more overlooked aspects of being an accidental landlord—Section 1250 depreciation.
What is Section 1250 depreciation?
As I discussed in a previous article, depreciation is the process by which the cost of a business asset is allocated over its useful life. The IRS allows you to calculate the depreciation of rental real property, such as a house. Furthermore, it allows you to deduct that cost from your real estate income.
This expense is known as Section 1250 (real property) depreciation. On most tax returns, Section 1250 depreciation is captured on Schedule E. For residential real estate, the IRS allows you to depreciate the cost of the property over a 27 ½ year schedule.
This means the IRS allows you to allocate the cost of the house over 27 ½ years. Each year, you can expense that year’s depreciation against your tax return. It’s not as straightforward as dividing the cost by 27 ½, because you have to make adjustments depending on what time of year you put the house in service. However, you could use an online depreciation calculator or tax planning software to do the math for you.
Let’s look at an example. The Smiths purchase a house, then PCS and rent it out beginning in January. Costs are below:
- Purchase price: $100,000
- Closing costs: $5,000
- Improvements: $10,000
- Total: $115,000
According to the calculator, the Smiths will be able to deduct the following amount each year:
- Year 1: $4,007.58
- Years 2-27: $4,181.82
- Year 28: $2,265.15
You’ll find that a house rented in January has a slightly different depreciation schedule than one rented in October. However, you can see that most Section 1250 depreciation (in Years 2-27) is a pretty consistent annual number.
Although depreciation is not an actual expense, the IRS allows you to deduct it from your income for tax purposes. The end result is a lower adjusted gross income, and probably a lower tax bill (although not always).
From the day you put your house into rental service (i.e. move out & put tenants into it), you are eligible to take a tax deduction for Section 1250 depreciation. And you should, for reasons we’ll discuss in the next section.
What happens when I sell my house?
When you sell your home, the IRS expects you to ‘recapture’ the Section 1250 depreciation, then calculate your tax liability accordingly. In essence, if you were entitled to a tax benefit while you were using the property, you’re expected to repay that benefit when you sell that property.
How much depreciation? Specifically, the IRS expects you to use the greater of the amount allowed (actually deducted) or allowable (what you were entitled to). The gain that’s attributable to recaptured Section 1250 depreciation may be subject to a 25% unrecaptured Section 1250 gain tax rate. IRS Publication 523, Selling Your Home, contains more information on how to calculate this depreciation.
The Section 1250 Tax Trap
I tried to research this, but couldn’t find any relevant articles online. So, here it goes.
Most military people are in a fairly low tax bracket throughout their careers. This is especially true when you look at combat zone deployments. It’s very easy to have tax years where you pay no tax liability because you have zero taxable income (Line 43 on your Form 1040).
If you have a rental property, the IRS entitles you to take Section 1250 depreciation deduction. If you have zero taxable income for the year, or are in the 10% tax bracket, this isn’t much of a tax benefit. However, when you sell the property, you’ll still be expected to recapture the depreciation you were entitled to, and you may be liable for the 25% tax on unrecaptured Section 1250 gain.
Without respect to the 3.8% Medicare tax, for people in the highest tax bracket (39.6%), this is a great opportunity: taking depreciation to lower the amount of income taxed at 39.6%, then repaying it at a 25% capital gains rate upon sale. For military people, however, this works in the opposite direction.
That is the Section 1250 Tax Trap: The inadvertent income shifting so you end up paying more than the actual tax benefit. It’s probably not something that’s done on purpose. It’s just a natural quirk of the tax code that few people know about, presumably since there’s an assumption that most people in low income brackets don’t have rental properties.
How do I address Section 1250 depreciation recapture?
If you have a house that you end up converting into a rental, you’re most likely not going to completely get out from Section 1250 depreciation recapture. However, there are some things you might be able to do to mitigate the sting.
1. Make sure you’re depreciating the right amount. Land isn’t depreciable. When you look to calculate the amount of your deduction, make sure you’re only deducting the value of the property itself. This amount should also include the cost of any major improvements (AC installation, renovations, electrical/plumbing upgrades), but not repairs.
2. Take your deduction each year. You might as well do so, even if you’re in the lowest tax bracket and there isn’t much tax benefit. In fact, if you missed deductions for previous years, you can (and should) look to file an amended return. In most situations, you can file an amended return either (whichever is later):
- 3 years after the original filing date (or due date that year)
- 2 years after you paid the tax due
3. When you sell your house, set aside 25% of your profits (including 25% of the depreciation you’ve taken or were entitled to take) until you file that year’s tax return. This sounds overly conservative, but you’ll want to ensure you have enough money for your tax bill. There’s nothing worse than thinking you’ve sold a house, just to find out that you now owe taxes on it and you don’t have the cash to pay the tax bill. This is especially disconcerting for people who didn’t make a profit, or who had to bring money to closing.
4. Have your taxes professionally done in the year of sale. This doesn’t mean having H&R Block do your taxes. Find a CPA or an enrolled agent in your area, and have that person do your tax return. Unless you’re a tax professional, you can assume that however you calculate your tax liability, it will be different from what’s prescribed by the IRS. Since your return might be at a higher risk of audit, particularly if you’ve filed Schedule E with rental losses, you’ll want a professional to calculate your tax liability.
5. Take this into consideration before you decide whether to sell or rent. By itself, Section 1250 depreciation recapture shouldn’t be the reason behind your decision to rent or sell. However, if you’re inclined to rent, you should look at the impact Section 1250 depreciation has on your cash flow. This includes the monthly rental cash flow as well as the cash you expect to receive when you eventually sell the property.
This article is not intended to replace tax advice. It only brings up points of consideration for when you’re looking to convert your personal residence into a rental property. However, the best approach is to consult with a tax professional or fee-only financial planner BEFORE you make your move.
Do you have experience placing your personal residence into service as a rental property? I’d love to hear your story. Feel free to post your comment in the comments section below.