Is reclaimed depreciation taxed in ADDITION to capital gains?!?

Question

When house is sold, does IRS tax BOTH reclaimed depreciation and capital gains? We have a small house in FL that we built in 1978 and rented out ever since. It is fully depreciated, and is in very rough shape. We've been presented with an $85,000 cash as-is offer and are inclined to take it; we live in CA and are weary of managing it long distance. We are debating the relative merits of a 1031 exchange with the proceeds, vs just biting the bullet and paying the 15% capital gains. (We do not have burning desire to buy another property but it's not out of the question if it makes profound sense financially). But then I read that 'the IRS will reclaim depreciation and it can be as high as 25%' - YIKES! Is that on top of capital gains?! Any suggestions would be appreciated.

Jon Holdman · Answer

No, its not on top of capital gains tax.  Its instead of capital gains.  When you sell a rental, the gains on the sale are split into two buckets.  The amount of gains up to the total amount of depreciation taken (or allowed, if that's greater than what you actually took) are subject to the tax on unrecapatured depreciation.  That's actually at your ordinary income tax rate, but currently capped at 25%.  The remaining gain is subject to capital gains tax.

In addition, be aware of what your gains really are.  Depreciation reduces your basis.  Your gains are the selling price, less selling costs, less basis.  Each year you take depreciation, your basis is reduced by that amount.  Of course, any capital improvements you made increase the basis.

So, if you bought it for $100K, and took $80K in depreciation your basis is $20K.  Now you sell for $200K with $15K in selling costs.  Your total gain is $200K - $15K -$20K = $165K.  That would be split into $80K gain at 25% tax for the unrecaptured depreciation plus $85K at 15% for capital gains.

Dave Foster · Answer

@Jeanne Miller, if I understand what you're asking, your original depreciable basis will be recaptured at 25% fed since you've reduced it to 0.  And the remaining difference between that original depreciable basis and the net sales price with the appropriate capital deductions will be taxed at the appropriate capital gain rate for you.

Steven Hamilton II · Answer

You recapture that depreciation at a maximum tax rate of 25% until you get to your original basis. Then you pay capital gains on the amount over that.

Scott W. · Answer

Got  it ty!

Jon Holdman · Answer

The tax on unrecaptured depreciation is defined to be at your ordinary income rate.   However, the rate is currently capped at 25%.  So if you're in the 28% or higher bracket, you're limited to only paying 25%.

Yes, @Scott W. you understand correctly.  Depreciation is a two edged sword.  You can take deprecation while you hold the property.  That reduces your tax bill based on your marginal rate times the amount of depreciation.  If you're at, say, 28%, then a $1000 depreciation deduction saves you $280 in taxes.  But when you sell you pay tax on that depreciation.  That is capped at 25%.  So the $1000 in gains from the depreciation would generate a $250 tax bill.

Again, though, you don't pay both the tax on unrecaptured depreciation AND capital gains tax on any one dollar.  The gains are divided into two buckets.  The amount of gain up to the amount of depreciation taken or allowed (whichever is greater) is taxes by that tax on unrecaptured depreciation.  The remaining gain, if any, is taxed at the capital gains rate.

Folks selling crummy rentals often try to spruce them up by touting the benefits of the depreciation deduction.  If you can take those, that may save you some money while you hold.  But even that may not be possible because the ability to use a passive loss to offset other income (which is what these sellers often claim) is subject to limits.  These sellers conveniently neglect to explain the back end where you then have to pay taxes on the gains that result from taking the depreciation.  Now, if you cannot take the depreciation as you go along, it will accumulate as a carry forward passive loss.  You can then use that to offset some of the gains when you sell.

Maybe @Steven Hamilton II can chime in.

Scott W. · Answer

https://www.biggerpockets.com/renewsblog/2015/08/23/depreciation-bite/

according to this article, by a CPA, - unless I am reading something wrong here- the only thing you pay back, on depreciation recapture - is 25%.

jon had me shaking in my boots! :)

Scott W. · Answer

@Jon Holdman if what you are saying is true, then one would be getting ripped off from a tax stand point.

let's say you purchase at $100k and sell at $100k (to make it simple) and had $40k of depreciation and you got a 25% tax break on the depreciation.

now I sell it. my basis is now $60k. now I pay back the depreciaton (25%) plus the a short term capital gain of 15% (assuming I am in that bracket)?

so all those years I got a 25% break and now I've got to pay it back at 40%? that makes no sense but IDK.

Really need someone (CPA preferred) who can explain this to us non-licensed peeps.

Blake Meester · Answer

@Champak Shah @Jon Holdman

Interesting conversation on the basis talk… maybe you are both right in a sense. Below is a simplistic view:

Basis is generally the amount an asset cost you. A gift or an inheritance would be different, but the same principle applies. The cost basis doesn’t change… but it is adjusted. During the period of your ownership their might be increases or decreases which will result in an "adjusted basis." Basis and adjusted basis are often different figures.

Your initial cost basis is the starting point. Adjusted basis is the figure we often use for tax gain or loss calculations. Both are very important to track.

Jon Holdman · Answer

Sorry, @Champak Shah but you're mistaken about basis.  The basis is reduced each year by the amount of deprecation taken or allowed, whichever is greater.

Champak Shah · Answer

Must talk over with Tax Adisor who does Real estate - taxes.

Capital gaines is paid at fixed rate

Depreciation Recapture is added as Ordinary Income -to your job salary

and you pay tax based on your tax bracket --

Basis will NOT change - basis will be what it cost you to build - many years ago ..

Is reclaimed depreciation taxed in ADDITION to capital gains?!?

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