My friend Forrest has shared his article about depreciation recapture: What Military Landlords Should Know About Section 1250 Depreciation. Sometimes it’s helpful to hear things from two different voices 🙂
You’ve owned a rental property for a few years, and it’s worked out pretty well. You’ve made a little bit of money most years, and you’re looking forward to cashing out the profits. And then you get the tax bill, and realize that most (or all!) of your “profit” is going to taxes.
One of the most confusing parts of having a rental property is understanding how the taxes will work when you sell the property. I’ve been a landlord for 20 years and I’m only fully understanding this now. (I’m a little slow sometimes.) And I’ll tell you what – I may have done some things differently along the way if I had understood the tax implications a little better.
Possibly the most complicated part is how you are taxed on the depreciation you’ve taken over the years. The taxes on depreciation recapture can make the difference between a profitable or not profitable rental experience. Because these taxes are paid at the sale of the property, not understanding them and including them in your profitability analyses can mean that your numbers are wrong. Failing to account for taxes can mean that you think your property is more profitable than it actually is.
Note: I’m not a tax professional or real estate attorney. Use this to figure out what you know, and what you don’t know, and consult with your professionals to see how this applies to your specific situation.
Understanding Depreciation
Every year, you depreciate your rental property. Depreciation is a loss on the value of your property, but it only exists on paper. Depreciation is only on the building — you can’t depreciate land. The land portion of your home is often about 20% of the total value, while the structure makes up the other 80%. If you don’t know the percentage for your property then check your property tax statement or your last appraisal.
If you’re not depreciating, you should be… because the IRS assumes that you’re depreciating, and they’ll tax you no matter what you’re doing. You’ll pay the recapture taxes whether you actually took the depreciation or not.
Depreciation reduces your overall tax liability by reducing your profit or boosting the loss on your rental property. For many landlords, this depreciation is the only reason they’re getting a tax benefit from owning a rental. The amount of depreciation depends on the value of your house (not the land), and the value of the depreciation is based upon your tax bracket. Many military families are in the 10% or 12% nominal tax bracket, so they’re benefiting from depreciation at the 10% or 12% rate (or 0%, especially with deployments.)
Don’t forget, depreciation recapture isn’t the only tax you need to worry about when you sell a house. Read Capital Gains Rules for Military Families to see whether you’ll be subject to capital gains taxes.
Depreciation Recapture
The idea behind depreciation is that whatever you’re depreciating is losing value each year. For most types of real property – carpets, computers, cars – that’s true. Our tax code generously allows you to claim that loss of value as a loss on your taxes for certain types of property. But that isn’t always true for real estate. In fact, real estate often increases in value. If you sell for more than the depreciated value of the property, you’ll have to pay back the taxes that you didn’t pay over the years due to depreciation.
However, that portion of your profit gets taxed at a rate up to 25%. (Even though you maybe were only benefited by 10 or 12% when you depreciated.) This is a very simplified explanation of the math, but good for estimates.
Here is an example: Let’s say you had a house that had a house value (not land) of $100,000 when you put it into service as a rental. You’d take about $3,600 in depreciation each year. If you are in the 15% tax bracket, you’ll pay $540 less in taxes each year due to depreciation. (The 15% tax bracket no longer exists, but we’ll keep it for purposes of this example.)
After five years, you sell the house for more than you paid. In calculating the taxes on the sale, you’ll take the $18,000 you’ve taken in depreciation, and pay $4,500 in recaptured depreciation taxes on the sale. (Again, this is the extremely simplified explanation of the math. It’s actually much more complicated.) You pay $4,500 in recaptured depreciation taxes even though you only benefited by $2,700 in taxes during the years you were depreciating!
When you’re dealing with a larger property value, or more years, the depreciation recapture taxes that will be due at the sale can add up to a lot. We own a house that we have been depreciating at almost $10,000 per year. After 10 years of rental, we’ll owe about $25,000 in depreciation recapture taxes, plus the other taxes that will apply.
The More Complex Math
Here’s the part of the post where I was going to put in many examples and explanations and charts and pictures about how this actually works. However, there are too many variables and I could not come up with a single example that was clear enough that it didn’t create more questions than answers. You’re going to want to get a tax professional to handle this in the year that you sell. Go ahead and meet with that person now and have them explain how your situation will unfold. I do not advise doing this yourself or using a tax preparation program.
I apologize that I couldn’t include more concrete examples, but I just didn’t think it would be responsible.
Can You Avoid Depreciation Recapture Taxes?
There are only two ways to avoid depreciation recapture taxes. Both of them are bad for you, but one of them might please your heirs.
If you sell at or below the depreciated value, then there is no depreciation to recapture.
If the house becomes part of your estate after death, the cost basis in the house is reset.
You can delay the depreciation recapture taxes on a sale by reinvesting the proceeds into another property, in a slightly-complicated tax move called a 1031 Exchange, or a Starker Exchange. If this interests you, you need to do a LOT of research and learn all the rules and details. I recommend BiggerPockets.com’s 1031 Exchange Guide: Basics, Resources, and Intermediaries.
You can NOT avoid depreciation recapture taxes by making the property your principal residence. You will still owe the taxes when you sell the property.
Depreciation is recaptured at the time of sale, whether you took the depreciation or not. So don’t think, “we just won’t take the depreciation.” I love the logic, but the IRS disagrees…
Other Taxes
Be sure to investigate the other taxes you may have to pay when you sell the property. This may include state and/or local income taxes to the state where the property is located and/or capital gains taxes.vThe sale of property might also bump you into the dreaded Alternative Minimum Tax (AMT.)
The Double (or is it Triple?) Whammy of Depreciation Recapture
Recently, someone said to me, “Depreciation recapture isn’t just a random tax. You’re repaying the money you saved on your taxes in previous years. It’s a wash.” On one level, they’re right. You’ve saved money on your taxes each year by reducing your income on the property by deducting depreciation. Now you’re just repaying all that savings. Except it’s not that simple.
Many military families are in lower tax brackets. Heck, there were many years that my family had ZERO tax liability. So that depreciation taken each year may provide very little value, or it may provide no value at all. But when you sell the house, the recaptured depreciation is included in your income, which often pushes you into a higher tax bracket, meaning you’re paying taxes on that recaptured depreciation at a higher rate.
Here’s a real-but-very-simplified example. In 2017, we sold a house. It had been a rental for 8 years, and the depreciation was roughly $10,000 per year, for a total of $80,000 in depreciation. During those years that it was a rental, we were in the 15% tax bracket, so that $80,000 depreciation saved us $12,000 in taxes over the 8 years. On our 2017 tax return, that $80,000 showed up as income on our tax return, pushing us from the 15% tax bracket to the 25% tax bracket. So when we calculated the depreciation recapture, we paid $20,000 in depreciation recapture taxes. As you can see, $20,000 tax payment for a $12,000 tax savings isn’t exactly “a wash.” It’s a little more complicated than this, but you get the point, right?
Conclusion
Taxes are an important part of the profit and loss equation of owning a rental property. There are many types of taxes that you may owe when you sell the property, including the taxes on the recaptured depreciation. Understanding these taxes from the beginning will help you make a much more accurate analysis of the value of your investment property, and will help you make better decisions about your property.
Update and An Example:
I was loathe to include an example because this stuff can be so confusing. But I explained it to someone yesterday and I think the explanation is pretty good. So, I’m copying it here:
It’s a slightly tricky formula. Let me try to explain using an office supply. Let’s say you buy a computer for $1000, and it is on a 10-year depreciation schedule. (It’s not, but it makes the math easier. Each year, you depreciate it $100 every year, and each year, your cost basis goes down $100. So, after year one, your cost basis in the computer is $900, after year two it is $800, etc. Let’s say you depreciate the computer for 5 years and now it’s cost basis is $500.
For most things in this world, the value/saleable price of the object goes down faster than you depreciate it. Therefore, after 5 years, you might be able to sell the computer for $200, so you wouldn’t have any gain and it wouldn’t be a taxable event
But if for some reason your computer was still worth $600, you’d owe taxes on the $100 between its cost basis (now $500 because you’ve depreciated it for five years) and how much you sold it for.
This is where it gets tricky. Any portion of that taxable amount (in this case, $100) that can be attributed back to depreciation gets taxed at a rate up to 25%. Then, you pay regular capital gains on the amount above that.
So let’s take a super-simple house case. Let’s say your original cost basis was $100,000. Houses are on a 27.5 year schedule, so you would depreciate it $3,636 per year. After three years of depreciation, your cost basis is $89,090. You sell the house for $110,000. You’ll pay depreciation recapture taxes on the $10,910 you depreciated the house, and then you’ll pay capital gains (if not exempt) on the $10,000.
Clear as mud, huh?
A little note: This article makes reference to tax brackets that no longer exist. I’ve changed them when it doesn’t change a bunch of math, but left them when the examples are otherwise solid.
I have sold my residential rental house. I have been reading lots of information on the recapture rules. Please explain the words in the last paragraph that say ” and then you’ll pay capital gains (if not exempt) on the $10,000″.
In that example, you have a net gain of $20,910, because the cost basis was reduced by the amount of depreciation. The first portion of the gains, $10,910, is attributable to depreciation and therefore taxable at 25%. The second portion, $10,000, is subject to the rules for capital gains, including the 2 out of 5 year exemption and the 10 year military extension on that exemption.
Does that make more sense?
Curious to know about that 10 year military extension on that exemption. Do you have a blog post about that?
This guy talks about this topic and refers to Kate on https://richonmoney.com/capital-gains-military/
Kate,
How would a person accurately determine the value of a rental property at the beginning of a divorce if its been depreciated over 10 years thus far and is attached to a $150000 tax carry over on top of the depreciation recapture and possible capital gains to the one who keeps the investment property
Good question! I’d probably ask my accountant to help me figure it out…there are a lot of different factors that you’d have to put in there.
Another option would be to just sell the property – it may not make the most financial sense but it might be easier and shed the emotional baggage that could come with the property.
Good luck to you!
This should be required reading for anybody turning a house into a rental!
Agreed. Also for anyone who currently owns one or considering buying one.
Very well written by someone who’s not an accountant nor a real estate attorney.
What happens if I purchased our residence in 2005 for $275,000. The FMV was $200,000 when we converted it to rental property in 2013 so we have been depreciating the building portion of the $200,000. Then in 2017 we sold for $234,000. My understanding is I don’t have a reportable gain or loss. Do I still have depreciation recapture? We do fall under the military rule that we lived in the house 2 out of the last 10 years.
In regards to the depreciation recapture tax, when you sell the rental property, do all those years built up of losses effect any of those scenarios? Or the un-allowable losses (from previous years) not affect the depreciation recapture tax?
I received a gift of property and I want to sell it. what will be my tax liability? how about the recapture of depreciation if I finance the property?
This is definitely an issue for a tax professional. And Enrolled Agent or tax CPA should be able to talk you through the various scenarios.
It’s clear that depreciation of the house must be recaptured upon sale. But what about the depreciation expenses of the washing machine (appliance – 5 year property) and the water lateral (27.5 year) that were taken while the house was rented out? Must these depreciation expenses be recaptured as well?
Ted, I have the same question! I tried to ask my accountant (via email) and he answered a different question. Your wording is much more clear. I will let you know what I learn.
Kate Did you get the answer on how to recapture appliances?
I inherited a rental house that has been depreciated for 30 years. It is in a revocable living trust. If cost base increases to its current market value . And I decide to move in it and make it my principal residence. Do I owe any recapture depreciation tax
Nice blurb here Kate.
You’re right. Too many landlords are blindsided by recapture when they sell – – primarily for lack of education. The best advice for 99% of landlords is to employ a CPA at the outset. Profitable buy and hold is more than simply collecting rent, paying the mortgage, and pocketing the difference.
The depreciation deduction really only “works” if your marginal tax bracket is 25% or higher.
Oh man… I WISH WISH WISH I knew this before I let my hubby sell his condo. He lived in the condo for 3 years, then we moved in together so he rented it out for another 5 years, not really making anything on the rent but still reporting it to the IRS. He was mainly renting it because he owed more than it was worth at the time. THEN last year, the market skyrockets, intrest rates are close to nothing, so his renters go buy a place and leave him with an empty condo. He decides to sell. He pockets about $5k. But now we owe closer to $10k because of the depreciation his CPA has deducted the last 5 years. We weren’t really looking to make a killing, but the rental was a pain and now we somehow are paying more than we ever made, even on the rental payments. I’m very sad and we are pretty upset. My hubby is self employed and it feels like he just can’t catch a break with this tax stuff. Wish we would have known this Kate… thanks for putting it out there.
Kate,
In your example above, I would like to clarify a couple things for your readers. When you depreciate an asset, you do so to offset income you make from that asset. When you sell the asset, the gain is broken into two categories for taxing purposes. The total gain is indeed $20,910. $10,000 of that is taxed as a long term capital gain if you held the asset for longer than a year. Depending on which income bracket you fall into, you will be taxed either 0%, 15%, or 20% on that portion of the gain. The second part of the gain, depreciation recapture is taxed as ordinary income (the reasoning being you used depreciation to lower your taxable income, now the IRS wants to sock it back to you) and depending on what income bracket you fall into, you will pay between 0% (not very likely) and up to 37%. A lot of people use 25% because it falls in the middle of these two extremes but your readers should know, if they make more than $157,500, their tax liability will be higher than 25%. Hope this helps.
Thank you Dan,
This clarifies so much! I was unable to find anything anywhere, explaining what you did in a few short sentences.
I appreciate you
Paulette
Regarding the 25% value for deprecation recapture, 25% is actually the cap, unless you took “excess depreciation”. Then you are required to pay the percent required by your actual income tax bracket. “Excess” depreciation, means that you depreciated the building, or improvements to it, using a more aggressive depreciation method than Straight-Line.
For example, if you used 150% Declining balance, or if you took 50% Bonus Depreciation in the first year on a water heater, then the amount greater than SL depreciation is taxable at the top tax bracket in which your total income places you.
Hello hoping for help on determining tax consequence if sell my current condo unit. I purchased in the 2006 boom market at 142k. In late 2014 I converted the condo from my primary residence to a rental. When doing my taxes for 2014 I set the fair market value at 95k based on what assessor had the building value at that time. So basically I’ve been taking 3450 annually in depreciation on my taxes since 2014. I may be able to sell for 110k to 120k which of course is less than what I paid in 2006. Any idea of what type of taxes I should anticipate if choose to sell? Thanks so much for any help
Kev, I could do some back-of-the-envelope math, but it wouldn’t be able to consider the variables and that wouldn’t be very responsible of me. I will point out that depreciation will be significantly offset by your loss, possibly to the point where you don’t have any depreciation recapture at all.
You are going to want professional tax assistance when you sell, it would be worth the energy and money to have a consult at the front end to be sure you are prepared and understand the situation in full. A kindly legal services person might be willing to give you a rough overview; it wouldn’t hurt to ask.
I’m sorry that you are in such a tough position!
Thanks Kate. Yes may just wind up hanging on to the property as rental. I’ve been lucky to have 3 decent renters so far and so making a couple hundred dollars monthly after taxes. Appreciate your understanding. I chose rather to walk and take a credit hit, to move on with life and got a house while the market was still recovering. I then rented the condo with hopes to sell when market picks back up, but one bedroom condo market still pretty low. I now have principal around 90k so figured if I could walk and make a little after taxes I would, but if huge tax hit I may just keep as rental for supplemental income in future.
Kev, it would definitely be worth visiting with a tax professional to work through the what-ifs. Because of the way that your value and depreciation recapture work together, there could be situations in which it makes no sense to hold on, even if you are netting a small profit. Alternately, it might make perfect sense to keep the property depending on the rest of your situation and what your long-term income timeline projects. It’s very personal and you can’t make the best decision without all the information.
Good luck to you!
Kate, Thank you for your posts. My husband and I are gifting a condo to our son. We converted it from a rental to personal property in March of this year. The gift date is December 1, 2018. The condo has been depreciated in the amount of $60,000. When do we pay the tax on that depreciation?
Kate, We bought a house in 1977 for $23,500 including the lot. We moved in 1992 and the house became a rental in Sept. 1992. We were told at the time if you didn’t depreciate, you didn’t have to repay with selling, so we did not. Years later we heard the law changed and we were not grandfathered in. We don’t know if we were given correct info. We then started depreciating. We are confused on how the recapture works when selling in our specific case. We know we need to talk to a CPA, but would like to try to have a little knowledge on our exact case before sitting down with a CPA. Thank you for any help you might offer.
Short answer from me (not Kate):
Your depreciation recapture taxes are calculated and due with your tax year 2018 return (the year you dispose of the property).
You also will need to file a gift tax form (709) since your gift exceeds the $15,000 annual maximum gift exemption.
Two side notes:
1) You should absolutely consult with a tax CPA prior to executing this plan. A CPA, not a “tax preparer”. This transaction is made MORE complicated by the fact that you are gifting (and not selling) depreciated property. It is quite possible that your son will “inherit” a portion of the depreciation and be responsible for those taxes when he sells the property.
2) Gifting appreciating property to relatives (heirs) prior to your death is almost never recommended. It can result in gift tax to you, and higher taxes for the recipient when they eventually dispose of the property. Unless there is a compelling reason to do so, you should reconsider gifting the property at this time. You will have a much clearer understanding of the tax ramifications after getting the counsel of a CPA.
Hope that helps.
-Mike
I bought a house in 1990 I paid 27000. I lived there until 2009 then it became a rental. I sold the property for 124000 in 2018. Minus all the fees and costs I left the table with 100,000 (no mortgage) In 2001 the house was worth 88000 I will pay the gains tax on the difference in the 88 to the 100 is that correct and pay the Recapture tax on what I depreciated over the 9 years at my taxable rate is this all correct. And any of my carry over losses will be usable to offset this income the IRS is trying to “stick into me” as the on comment stated
Bryan, this question is more complicated than the details you’ve provided, and I am not a tax accountant or Enrolled Agent. I suggest that you work with one of these professionals to ensure that you are paying the right amount of tax on your sale. While I could speculate on your final situation based upon the details you’ve given, that would be irresponsible of me.
Aloha Kate,
We have a property that we purchased in 1995 and have been steadily claiming depreciation every year. We plan to sell that property and purchase another property of equal value using the 1031 exchange to avoid ridiculous taxes. My question is what happens to all of that depreciation that we benefited from for all these years? Does the depreciation reset and we begin another depreciation on the new property?
Scott, if you do a 1031 exchange, the depreciation (and capital gains, if any) move over to the new house. The only way to completely avoid depreciation recapture is to hold the property (or the 1031 replacement property) until you die. At that point, the depreciation goes away entirely.
I hope that helps.
We sold a home in Sept of 2018. We let our realtor handle things for us as we were living in a different state at the time of the sale of our rental. I spoke to her about the depreciation recapture though and they advised me to speak to a CPA. You’re saying it happens at the time of sale? So they should have taken the deduction for the depreciation recapture then? I was thinking it was when we file our taxes and we did go with a CPA this year who says it didn’t affect or take anything for that from our refund. How do we go about paying for it now?
The taxable event occurs at the time of sale, but you report it (and pay for it) on your 2018 income tax return. Your tax return should include a Schedule D, Capital Gains and Losses form and an Unrecaptured Section 1250 Gain Worksheet. Your unrecaptured depreciation should show up on your 1040 on line 13, which will affect your overall income tax due.
I’d ask your CPA to show you where and how the sale of the property is reported. Even done right, it is really confusing.
We bought a house in 1998 as the primary resident and lived in it until 2009 when we purchased another primary resident. We could not sell the house (horrible market) and rented it out in 2010. We sold the house Dec 2018. Can you use any cost for additions, new roof – things done prior to renting to offset the depreciation?
Cindy, this is definitely a question for your tax professional. And you want a tax professional to handle a year with the sale of a house that has been a rental.
If you put on a new roof while it was a rental, you should have been depreciating that roof all these years, which would actually increase your recaptured depreciation. If you put on the new roof while it was your property, it will probably impact your cost basis.
You want a professional to look over this carefully!
Thank you – we hired a CPA that specializes in taxes. We wrote off everything that was done to the rental whatever year that it occurred. New roof, addition etc was done when we lived there and can be added to the cost basis. YAY for keeping all the records.
Wow! We’re a one income military family with a few rental properties in different states. It took many links to find this article but I’m glad I found it. I just found out my accountant who has been doing our taxes for 10+ years has not been depreciating 2/3 of our rental properties, when I asked her today why she wasn’t doing it, this was her response…
“First the IRS doesn’t assume that you use depreciation
Second if you get earned income credits the lower the income the lower the credit
So you can see that more deductions are not always a good choice. Especially since depreciation is not a true deduction – you essentially have to pay it back when you sell the property”
I’m at a loss and do not understand her response, from every link I’ve clicked on in regards to depreciation it says take it now because you will pay for it in the end no matter what. Maybe you can help me understand what this means?
You’ve brought up an interesting question. Every tax professional I know refers to the IRS instructions that you must recapture depreciation that was “allowed or allowable,” with allowed meaning that you actually took it, and allowable meaning that you could have taken it. But just this morning, I’ve found two articles suggesting ways to skirt this requirement. I’ve put out some feelers to my tax professional friends and I’ll let you know what they think.
Hi Kate
I had 2 rentals I sold in a 1031 = purchase of one. I followed all the rules of the 1031 exchange, My question for you is Q. The duplex & single family properties were kept rented while I did maintenance and repairs
but how will this affect my write-offs
New roof on one I order it in Oct. 2017 but they were so busy the roof didn’t go on until Feb 2018 but sold the duplex Oct 2018. ( note when I purchased this duplex it needed a roof ( 12 years later we could repair it anymore my tenants had multiple leaks. ) How will that new roof be handled in my taxes. oh and carpet in one unit & house.
These are definitely questions for an experienced tax CPA or enrolled agent. I’m not a professional, and I don’t have enough information to even speculate. Good luck!
I’ve owned and rented a residence for 13 years, cost basis $150,000. Could I gift it or sell it to a relative and would the basis reset then? What would be the tax rate (2019) if I sold it myself this year? It’s in my name only, could I gift it or sell it at a low price to my husband?
You definitely want to talk to an experienced tax advisor. As I understand it, both the capital gain and the depreciation stays with the property if gifted, and the recipient would eventually owe those taxes when it was sold. https://www.bankrate.com/finance/taxes/calculating-capital-gain-tax-on-gifted-rental-property.aspx
The depreciation recapture tax is more complicated than anything described above. I have searched and found many mentions in tertiary sources of the recaptured depreciation being taxed at 25%, or at ordinary income rates up to a max of 25%. We found neither to be quite correct.
In following through the forms (IRS & Turbotax), here’s how it worked for us, and we haven’t figured out why: Taxable income before long-term capital gains and depreciation recapture is $33,354. Turbotax and the IRS forms subtract that from the $77,200 that is the top of the income bracket for which we could still get a 0% rate on long-term capital gains, leaving $43,846 of “room” under that $77,200. our depreciation recapture is 66,507. Turbotax and IRS sort of “fill-in” that $43,846, i.e., $77,200 – 33,354 = $43,846 which goes on Schedule D worksheet and is taxed at an ordinary income tax rate of 12%. I don’t see any logic to that calculation, but I like the tax rate so great so far. But we still have $22,652 of depreciation recapture yet to be taxed ($66,507 of depreciation recapture less $43,846 taxed at ordinary income rate). This amount goes on line 38 and is taxed at 25% as stated right on the form. Our capital gains that were not recaptured depreciation are then taxed at the capital gains rate of 15%.
OK, I’m glad our recapture wasn’t all taxed at 25%, but if it is supposed to be taxed at our ordinary income tax rate up to a maximum of 25%, why wasn’t it taxed some at 12% and some at the next bracket amount of 22%, and we shouldn’t even have enough total income to get to the 25% maximum.
Can anyone explain why it works that way? Can anyone tell me where the tax code actually states what the tax rates are on the recaptured depreciation?
And all my searches have not yet turned up any IRC source for the 25% rate or the ordinary income rate up to 25%.
This has been the most helpful post I’ve found on the internet to describe why our accountant just told us we owe $23,000 after selling our rental house in 2018 that we’ve owned for 12 years! Should we have an actual CPA look over our tax return, just to make sure our accountant (who has 10 years experience, but is not a CPA) found every possible deduction? I wish we would have understood this better. Learning a BIG (and expensive) lesson.
Wondering if Kate or anyone else can answer this:
– Bought house 5 years ago for rental
– Depreciation recapture will be around $60K
– Profit (before brokers fee & tax) will be about $400K
– I haven’t been employed for a few years, so my income is zero, or minus after rental depreciation/expenses.
Anyone knows what taxes I’d need to pay with the above scenario?
Thank you in advance.
Reddy, you really want to meet with an experienced tax professional to work out all the details. There are a lot of different factors that go into the calculation of these taxes. Comments from anyone, even me :), can’t even begin to consider all the possibilities without a ton more information.
I have owned a residential rental property(three apartments in a brownstone in Brooklyn) since 1979 and sold it this year for a profit above the amount of depreciation taken. During these 40 years I have spent money for capital improvements, appliances, carpeting, etc. in addition to repairs and other non-capital items. The cost of the building in 1979 plus the capital costs up to 1980 were depreciated using the declining balance method. They have all been fully depreciated. The capital costs for the period 1981 through 1986 have been depreciated using the Accelerated Cost Recovery System(ACRS) and all have been fully depreciated. The capital costs from 1987 to the present including improvements plus appliances, carpeting etc. have been depreciated using the Modified Accelerated Recovery System(MACRS) and all but four items(under the straight line method of depreciation allowed by the IRS i.e. 27.5 years)have been fully depreciated. Is all of my depreciation considered section 1250 property and subject to tax at 25% as unrecaptured section 1250 property. Note that some of the property was not depreciated using the straight line method.
Mr. Buchner, this is a question for a highly qualified tax professional, which I am not. There are too many variables for me to even point you in the right direction.
Mr. Buchner, I rarely talk to anyone who has as thorough tax/asset documentation as you described. Most people barely know what they paid for it and what year it was.
I too am looking into capital improvements and how it might affect the outcome if I chose to sell our rental.
Hello, we are in need of selling a rental, PP $55000. in 1999, received approx. $4800. in rent yearly, family member renting, low rent. Repairs to home are not over $10,000. RE taxes averaged $1500. per year. We are in the zero % tax bracket at this time. Home needs some repairs, looking to sell on a private contract for $200, to $250, what happens to the depreciation tax and capital gain tax if sold on a private contract?
Capital gains and depreciation recapture taxes are applied regardless of the type of sale. You definitely want to talk to an experienced tax preparer (CPA or enrolled agent) to work out all the details of your particular situation.
Hi Kate,
Thank you for your site. I refer to it often to review what your readers and commenters (and you yourself) are saying about recapture tax on rental properties.
I wonder if you or some of your knowledgeable readers would comment on two questions I have: 1) If a person does a 1031 exchange with purchase of a higher priced property, could he live in part of it and rent out a portion at least equal to the value of his sold rental property? 2) If a person donated his rental property to a 501c-3 charity, how would that impact his taxes? Especially if the property were valued at a) what he paid for it, b) what he paid less depreciation, c) whatever it appraised at, up or down his purchase price? Best to give it as inheritance, during life time during same year he’s taken lots of capital gains, or while living?
Are there any really problematic pit-falls that people fall into in doing a 1031 Exchange that we all should be alert to?
Awaiting hearing from you again.
Virginia
Hi Kate,
Great site. I have a property that I inherited in 1996 but did not place into rental service until 2003. Reading some of the discussions, I am a little confused as to which basis I should use for depreciation. The cost basis at time of inheritance was $300,000 but by 2003 the fair market value (FMV) of the property was about $370,000. Do I use the inherited basis or the FMV of the property when placed into service.
Thanks,
Dwight
We owned a rental propery in MA, purchesed for 73k, owned and rented it for 25 total years, with only living in it as our primary address for one year ,2009-10 ( after the rules changed for the purpose of figuring eventual capital gains down the road. We sold the MA condo in Dec 2017 in a 1031 exchange, for 417k , and purchased the replacement rental property in FL fir 502.5 in Jan of 2018, which has been rented for two years. We have our primary residence in FL, but now, due to health and other circumstances, we are going move in to the rental, and convert it to our primary, understanding that we nerd to own it for at least 5 and lived in itvas primary fir at leastvtwo of the last 5 years, to take advantage of the 121 exclusion as much as possible. If and when we ever have to sell the now primary condo, aquired in the 1031 exchange, from where do we begin to count the total qualifying and non qualifying years, to estimate the amount of capital gains erased for each year we remained in the aquired property, now our primary. Since everything gets rolled into the aquired prolerty in a 1031 exchange, do we count total years owned from the time we purchased the long held original condo or only from the years owned and lived in the aquired, converted property? We need to have this clarified for us. Thanks so much
Merri, you really need to sit down with an experienced tax professional, such as an Enrolled Agent (EA) or tax CPA, to go over your specific details. You have a lot going on and you don’t want to rely on me.
Very thankful to run across this!
After reading through all the Q’s and A’s my retired husband and I have decided to keep our mortgage free rental house rented, enjoy the income and leave it to our kids!!
Thank you Kate and all the responders here!
I thought Trump fixed the tax code. These are the same ones from before the tax change. Funny he missed this since he owns so much property. However here’s my question. We have a vacation home which we rented to snowbirds in winter and we used for vacation in the summer. If we sell this house how will we be taxed? Thanks, Babs
You just posted this to a FB group we are both members, but I cannot find the FB post. Great explanation of depreciation recapture, thank you. But it is a discussion in a vacuum when considering the overall profitability of a rental property–I am sure you understand this Kate, but posting for others who may not see the whole picture. For the years that you are renting (and depreciating) the property you are hopefully using all that essentially Free rent money to pay down your mortgage, pay insurance and property taxes. It does not seem to be a thorough evaluation of property “profitability” without also considering the money you walk away with after paying off the mortgage, because had you paid the mortgage smartly (additional principal to reduce overall interest payment requirements) hopefully the equity of the rental that your tenants built for you, still makes the overall property “profitable” and even after paying that recapture tax, you walked away with considerable cash in hand.
I talk about the big picture in numerous posts, but perhaps a quick blurb would be appropriate here. It will, of course, have to include all the variables, particularly how often military families are “taking” the depreciation in years where it doesn’t benefit them at all because they are in a low or zero tax bracket, but “repaying” it in higher tax brackets. Last house we sold, we depreciated years during which we paid no tax at all even without the depreciation, due to CZTE time, lower income, and a large family. And yet we paid nearly $20,000 in recapture…not exactly a wash. Every situation is different, but in my experience counseling thousands of military families, walking away with considerable cash in hand does not happen nearly as often as it might seem on the surface.
This is a very helpful article. As much as everybody hates to learn the full scope of the taxation cost of doing business, learning that cost in advance may allow property owners/taxpayers to consider whether, and how, they might reduce their tax burden. Anticipating a few months of unemployment after leaving the military? Might be a good tax year to sell the rental property. Have kids growing up who will cease to be dependents (for tax purposes!) 6-9 years from now? Might be a tax consideration to consider there, too. The silver lining of a real estate market dip might be selling a long-held property at a price below your cost basis, while also cashing out much equity to put towards other investments.
I purchased a short-term rental property in 2005 for $306,000.00 through a 1031 exchange. I placed $143,000.00 cash from the sold property to purchase this one and I’ve taken approximately $91,000.00 in depreciation over the year.
I sold the property for $255,000.00 in 2019. Is there any advantage to me that I’ve sold for less than what I purchased it for, or is my cost basis the original price minus the taken depreciation that looks like this:
THIS IS A QUESTION
Purchase: $306,000
Depreciation taken: $91,000
Adjusted cost basis: $215,000
Sale price: $255,000
Recapture of depreciation (25%) $22,750
Long-term capital gain on the amount between the new adjusted cost basis and sale price: $255,000 minus $215,000: $40,000 x 15% capital gains = $6,000
Total tax liability for sale: $28,750.00
Rob, you definitely want to meet with a tax professional who understands 1031 exchanges. It would be irresponsible of me to comment on your position because a) I don’t have all your other information and b) I’m not a practicing tax professional. My biggest question from what you’ve laid out is where you are factoring in the depreciation and capital gains that you carried over from the previous property.
In general, yes, your lower selling price may/probably will have an impact on your total tax liability.
Here is another article on the same subject: https://www.katehorrell.com/military-landlords-section-1250-depreciation/
You may also find some useful information here: https://www.katehorrell.com/favorable-tax-rules-for-military-when-excluding-capital-gain-from-sale-of-principal-residence/
Rob – Sorry this played out the way it did. It’s a good (bad) example of having a tax liability on a sale that – on face value – appears to have actually lost $.
You need to run all your numbers by your tax pro. When you do, I think you’ll find that you’ve estimated your tax liability high by about $16K. There are a couple of gains tax calculators out there that might help you with your estimate. I like https://apiexchange.com/capital-gain-tax-calculator/.
Thanks, Kate. I figured that would be the answer. It’s even hard to find a tax pro that can explain it. I was told by a tax pro that I would not pay the tax on the sold 2006 investment that initiated 1031. They said it sort of starts all over again once you purchase the like-kind investment. If that was the case I surely don’t ever see how anyone can ever afford to sell without holding the investment for a lifetime.
So to fill in the blanks, I purchased a property for rental in 2005 for $172K and sold it 366 days later for $400K. $145K (via 1031) cash went to purchase the property I just sold. The rest went to another property I still hold. Your feedback regardless of not being a tax pro is appreciated.
The authors of the two articles I linked in the previous comment are both well-versed in the subject, and one is a tax professional. They might be a good place to start.
Hello, I have a question on my rental property that I will sell in April. I understand depreciation recapture and capital gains on the house. My question is around the new roof that was installed while the house was a rental. To simplify math, let’s say it cost $2750, installed in April 2017. It’s been depreciating (27.5 life) at $100/year for 3 years. I will owe depreciation recapture on the $300. The roof still has $2450 left that wasn’t depreciated. Does anything happen with this “asset”? Do I get to roll that value back into the cost basis of the house or expense this amount?
Thanks,
Mike
Is selling a rental home is really worth it then?
Is getting in the rental business even worth it after all? By the time you pay mgm fees, repairs, and taxes , you are not left with much profit honestly. I guess it all depends on the rental property. I know that I have not been getting a huge annual returns and now if I sell it, I am on the hook for this huge captial gain taxes. I feel that I am stuck and maybe I should just.keep it as rental property for ever. On the other hand, if you own a personal home, then you don’t have to pay taxes on captial gains
Hello Kate,
My rental house has taken depreciation for 8 years. Can I change to do not take depreciation way for rental in the future ? My income tax bracket rate is usually 12%
Thanks,
Cathy
Even if you don’t take depreciation on the rental you will have to “recapture” the depreciation you were supposed to take. You can’t avoid the recapture by not taking depreciation in the first place. Too bad as for some lower income landlords it might be better not to take the depreciation if it weren’t for this rule.
I’m considering selling a house that I’ve owned since 1995. During the time I’ve owned it I have used the house in different ways. For most years it was my primary residence. Some years I rented out rooms and depreciated the house accordingly. Some years I had a home office and depreciated accordingly. Some years I had a granny unit in the back that I rented and depreciated.
The phrase “allowed or allowable” is confusing to me, because what was allowed or allowable changed many times over the years. Can’t I just look at my last 25 years of taxes and put the exact amount I depreciated as the amount I need to recapture?
Thanks,
Todd
Todd, you absolutely need the help of a tax professional (EA or tax CPA) who has experience with rental properties.
If you are absolutely sure that you accurately depreciated the property over the years, you could in theory just add up the amount that you depreciated and use that figure as part of the tax calculation. But that’s something that I would want a 2nd or 3rd set of eyes to review. Even as someone who understands it, the form was not clear to me. My CPA had to walk me through it line by line so I could see how the calculations matched up to the concept.
Good luck to you!
Here is one for anyone to answer. My wife may be selling a condo which she has depreciated over the years for a total of $52,000. The purchase price will result in her making some money but but the net sales price minus the adjusted basis will result in a gain of $27,000 which is less than the depreciation over the years of $52,000. It is my understanding that this will result in the $27,000 being taxed at whatever will be our ordinary income tax rate. The $27,000 is listed as a gain in Part 1 of Form 4797 (Sale of Investment Property), but when it comes to taxation the unrecaptured depreciation requires the use of the Tax Worksheet from Schedule D will treats it as ordinary income instead of a capital gain.
I may end up selling a stock at a loss of $44,000 which must be listed as a long-term loss on Schedule D right above the gain of $27,000 transferred over to Schedule D from Part 1 of Form 4797. Since this loss will be greater than the gain of $27,000, there will be a net long-term capital loss on line 16 of Schedule D. Schedule D says that if line 16 is zero, or less, that one does not have to calculate the unrecaptured depreciation. This would make it appear that the $27,000 in unrecaptured depreciation will not be taxed and neither will the gain because of the long-term loss from the stock sale. Could it be true that since the loss of $44,000 is greater than the $27,000 gain, the gain is not taxed; and that the $27,000 of potential unrecaptured depreciation will not be taxed either as per line 16 of Schedule D which says that if line 16 is a loss, one does not have to calculate the unrecpatured depreciation in line 19, as that calculation is to be skipped and one proceeds to the Qualified Dividend and Capital Gain Worksheet to calculate the tax due.
Jack, you really need to work with a qualified tax professional, recommend an EA or tax CPA, to map this all out. Both halves of your question are complicated individually, more so when put together. No one here should be giving you any advice beyond “find a professional.”
Best of luck to you.
Jack, I like your thinking. But that’s only a fair comment for the ‘good guys’ (us)
Kate – I brought a property for 300,000 14 years ago.
I loved there for 7 years and then converted to a rental for the last 7 years. I have been taking depreciation over the last 7 years. (270K Cost of the Building and 30K cost of land. Taking depreciation of 10K per annum)
I am now planning to sell my property to my son for a low price of 200,000 (Depreciation taken so far is only 70K). In this case do I need to pay any depreciation capture or taxes? My son will be making this his Primary Residence and so if he eventually (3 years from now) sells it for say 400,000 then he should not have to pay any taxes, right?
Sam, specific situations always require the help of a professional in that field, so I advise that you talk to a tax professional.
Selling at a loss does change the depreciation recapture calculation, and it is possible that you would not be required to pay taxes. However, I would definitely look into any rules about arms-length transactions and selling at less than market value. I would guess the IRS has some rules about selling low now and then your son selling much higher in a short period of time. But that’s not my area of expertise!
Good luck to you!
1.If I gift (not sell) my rental property to my child, should I report depreciation recapture on my tax return (1040)? I know I need to file a gift tax form (709) .
2.To continue on the1st question. The child received 2-bedrooms single family house as a gift from the parent. A couple of years before gifting, the parent installed a new roof on the house and reported depreciations on his tax return. The house became the child’s primary residence. He is renting one of the bedrooms. Can the child to continue depreciating the roof? By 50% – because the child rented half of the house?
Mary, you need to sit down with an experienced tax professional – you have a complicated situation.
Kate, others might have already pointed this out but you have incorrect info in your example. You only pay 25% tax on your benefit ($2700) not the entire depreciation amount of $18,000. That would make the taxes super regressive and punish the poor while benefiting the rich.
Viktor, you might want to review your information. The tax is on the entire amount of unrealized Section 1250 depreciation, not just the tax benefit that was received. It is reported on Form 4797 Section I Line 2e, “depreciation allowed or allowable.” That gets transferred to the Schedule D, where it is taxed at a higher rate than regular capital gains.
I didn’t write this article, it was written by my friend Forrest Baumhover, CFP, EA. https://lawrencefinancialplanning.com/our-team. Everything in this article appears correct to me, and I explain the same concepts a different way in this article. https://www.katehorrell.com/understanding-depreciation-recapture-taxes-on-rental-property/
I also ran your comment past my tax advisor, who replied, “He is not correct.”
If you don’t believe any of us, you are welcome to check out any of these other resources on the subject:
https://www.millionacres.com/taxes/depreciation/what-unrecaptured-section-1250-gain/
https://www.investopedia.com/terms/u/unrecaptured-1250-gain.asp
https://www.irs.gov/publications/p544
https://smartasset.com/taxes/depreciation-recapture
Hi, long shot question. If siblings own a home together, 1 has lived in it for 6yrs as their primary and sis#2 has since moved into her own primary elsewhere. The mortgage is in sis#2 name because it was just easier than getting another, and sis#1 pays the mtg and everything for the home since. If Sis2 is claiming the home on her taxes for the interest paid on the mtg. Sis#1 does not claim anything home related on her taxes. Because she is claiming it and it’s her second home will there be a Recapture depreciation tax on her half of the money only? or will it affect the whole amount? Both names are listed on the deed. Is sis#1 getting the short end of the stick here how do people handle things like this, there has to be others out there? I am not seeking professional advice, I am only looking for an opinion, or knowledge that can shed light on a situation like this. I don’t want to Any insight or heard of something similar I’d really love to hear it.