Depreciation and tax liability

Buying & Selling Real Estate
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Depreciation and tax liability

Carmen Ngai
Member since 2019 · 6 posts · 1 vote

Hi Everyone, 

I am just starting out and looking for a rental property.  So, I have lots of questions, especially about depreciation.   I'd like to evaluate how it affects the tax consequence when I sell it some day.  From what I read, only the structure/building is depreciable. Land does not depreciate. It assumes in 27.5 years the structure is completely depreciated and worth $0. I ignore the closing cost and upgrade for simplicity sake at this point.  

Here are 2 hypothetical situations:

1.  Condo $500,000

If I buy a condo for $500,000, assume in 27.5 years I sell it for 2,000,000. 

Since only the structure itself can be depreciated.  For Condo, you don't own land.  So, from the accounting stand point, the condo after 27.5 years worth $0.  The cost basis will be $0.  

Realized gain will be $2,000,000

The part that is tied to the depreciation deduction is $500K the tax rate will be 25% (ordinary income tax rate).  $500,000 x 25% = $125,000

The rest of the gain will be taxed as long term capital gain, so, $1,500,000 x 20%, which is $300,000

Total tax due:  $425,000

2. Townhouse $500,000, sell in 27.5 years for $2,000,000.

Since the townhouse is sitting on a little piece of land, I assume a portion of the townhouse cost is land.  Lets assume the townhouse structure itself costs $200,000, $300,000 is the land.  After 27.5 years, the $200,000 structure is completely depreciated to $0.  The cost basis for this townhouse will be $300,000

Realized gain will be $2,000,000 - $300,000 = $1,700,000

Long term capital gain tax will be $1,700,00 x 20% = $340,000

Is my calculation correct?

The IRS said the whole “allowable depreciation amount” would be recaptured. What does “allowable depreciation amount” mean? Does it mean based on the accounting principals how much the property has depreciated? So, in the above case of the condo, then the allowable depreciation amount would be $500,000?  I understand IRS does not want taxes uncaptured when someone makes a profit.  Because of depreciation, a lot of the time the rental property by the book has a rental loss, which the landlord can use the rental loss allowance up to $25,000 to offset the regular income, so, it is kind of fair to recapture the income tax of that $500,000.  

But what if I am not eligible to use any capital loss allowance to offset my regular income, that means I couldn't take full advantage of depreciation, will the condo allowed depreciation amount still be $500,000?  

I imagine at the beginning with mortgage interest, depreciation...etc, from taxation stand point there would be a rental loss.  If I cannot use that to offset my regular income, can those losses be carried over to offset my gains in the later years?  
 

Any guidance is welcome! 

Thanks

Carmen

  

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  • Frank Chin
    Investor · Bayside, NY · Member since 2017 · 1k+ posts · 1k+ votes
    6y

    I invested in condos and have gone thru years where my income precluded me from deducting losses against my personal income.

    In so far as the land building ratio goes, the CPA's I used allocated an approximate amount to land, like 10%. For condos I had, it's not an easy number to come up with. The condos where I invested was a former high school sold by the city to a developer, who went bankrupt, project took over by a bank, the bank went bankrupt, took over by the RTC, and then a bank. They had trouble selling the condos, auction them, and only sold half, 30 out of 60. When I told this to my CPA, he said, we'll use 10% for land and let them dispute it.

    The old high school is six stories, 104 condos, the former grounds associated with it was converted to parking lots for the unit owners, and all were assigned spaces. So there is empty land, there is building, there is land where the building sits on, and I bought the condos at $40K each and I not going to spend $10K to figure out the value of the land associated with it. Ever tried getting the square footage of the parking area, and the square footage of the building from the management company for the condo? They couldn't even get to changing lightbulbs in the hallways.

    As to deductions there were years I could not deduct against income, my CPA used a holding account to accommodate this. I had a high paid IT job, then later bought some businesses where I claimed little income for myself and used the deductions held in the holding account to offset the small income I did declare. I was glad it turned out this way as the holding account was almost a savings account for me when I was making good income and subsidized me when I was in business. I recall I still had some unused deductions in the holding account when I sold the property and it was applied during the sale, which made recapture a little less painful. 

    That's the general idea on how it's handled. I saw your numbers, generally seems right, but too early in the morning to run actual numbers. 

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  • Bob NortonPro Member
    Accountant · Slidell, LA · Member since 2019 · 382 posts · 272 votes
    6y

    @Carmen Ngai You are essentially correct in your calculations.  In example #2, you did not add the depreciation recapture tax of $300k x 20% = $60k.  So, your total tax in example #2 would be $400k.  This, of course, is assuming that you do not qualify for the 15% long-term gain tax rate.  As you show in your example, condos are all building with no land.  The land is owned by the condo association.  So, you can depreciate the entire cost of the condo.

    "Allowable" depreciation means that if you failed to deduct depreciation in the past, the tax code ignores that and you will have to recapture depreciation expense for the total amount that you were eligible to deduct over the period that the property was in service, even if you did not deduct the depreciation in the past.  So, you want to make sure that you deduct depreciation each year for your rental properties.

    Now, if you have been unable to deduct your rental losses over the years because of your adjusted gross income (AGI), then those losses are suspended until your AGI is lower, or until your rentals begin generating net income, or until you sell the property.  Generally, rentals begin generating taxable income after several years due to increasing rents.  In those years, you will be able to reduce that net income by any suspended losses from the prior years.  If you sell a rental property with suspended losses, then you get to deduct the suspended losses for that property in the year of the sale.  And, if you have not been able to deduct any losses for that property due to AGI, then the suspended losses will offset the depreciation recapture income.

    I hope this answered all your questions.

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  • Carmen Ngai
    OP
    Member since 2019 · 6 posts · 1 vote
    6y

    @Frank Chin @Bob Norton

    Thanks so much!  Those are all useful information.  I am glad the loss can be used later for the "rainy days" (when I am actually making money).  

    Yes!  I forgot to add the depreciation recapture in my scenario #2 calculation.   The structure costed $200,000, so the math should be:

    Realized gain will be $2,000,000 - $300,000 = $1,700,000

    Long term capital gain tax will be $1,500,000 x 20% = $300,000

    Depreciation recapture: $200,000 X 25% = 50,000

    Total tax due: $350,000

    Am I right?  


    @Bob Norton

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  • Bill B.
    Investor · Las Vegas, NV · Member since 2013 · 8k+ posts · 10k+ votes
    6y

    You’re getting there but....

    You’d pry be closer to $400k townhome and $100k land. You went with what the building was worth and took that away from the total and assumed the rest was the land value. But together they are worth more tha seperately. Try it the other way. Would you buy that tiny parcel of land for $200k? Or more likely $100k or less?

    Secondly, although you have more depreciation recapture on the condo, you also got to deduct that larger depreciation while you owned it. If your tax rate is over 25% combined you actually save money with recapture, if it’s less than 25% you pay more. BUT, you pay it in the future, so even if it’s exactly the same, you got to use the money for 27.5 years for free. 

    Thirdly, we know you’re way smarter than to sell and pay all the taxes. So you’re more likely going to die in the next 28 years (sorry), or, exchange it for a $2million beach house, or mountain house, or island house, whatever...  then you’re going to rent it out for a year and decide you don’t like renting it out and move in to it and live out the rest of your days in that house never paying the tax or the recapture, in which case you want the larger depreciation. 

    GL. The math is fun sometimes but what you do in 27.5 years changes which is better today, but it’s certainly not the reason to choose one or the other. As they say, don’t let the tax tail wag the investment dog. 

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