I am a newbie passive investor and trying to understand tax implications of selling a rental property which has passive suspended losses. I don't have a primary residence (i myself live is an apartment), and recently bought a single family home. And decided to buy it as a rental property instead of making it my primary residence (and i am evaluating if thats the right decision or not, by running tax implication scenarios in my head).

Most examples i see either explain depreciation recapture and suspended losses separately, or they take an example where profit from sale is so big that it is conveniently separated into parts that go towards depreciation recapture taxes and have still room left over to offset suspended passive losses. I want to understand what happens when depreciation recapture and suspended losses are too big to cover the profit from sale of property. What part of proceeds to suspended losses offset? Here is an example -

I buy a single family home for $500,000

After a decade, i sell it for $550,000 (lets assume there are no other selling costs like agent fee etc to keep math easy)

During this decade, My rental income was $35,000 every year

During this decade, lets say my expense (interest, insurance, HOA, etc) was $30,000 every year

Depreciation on property was $15,000 every year

Every year, i showed passive loss of $10,000 (expenses = $30,000 + depreciation = $45,000. Income = $35,000) which carry over (suspended passive loss)

Now as i understand, at the time of selling, this is the situation -

Depreciation claimed over decade = $150,000

adjusted cost basis of the house = $500,000 - depreciation = $350,000

Suspended passive losses = $100,000

Profit from sale of house as per IRS = Selling price - adjusted cost basis of house = $550,000 - $350,000 = $200,000

Now IRS wants depreciation recapture taxes on $150,000. And i want to use my suspended passive loss of $100,000 to reduce my taxes. But profit from sale of house is only $200,000 (not enough to do depreciation recapture as well as recover suspended losses). So how will taxes be calculated? I can think of two scenarios, please tell me which one is correct (or maybe both are wrong)-

----------------------------------------------------------------

(A) passive losses first eat into profit on sale and remaining goes towards depreciation recapture

profit from selling - suspended losses = $200,000 - $100,000 = $100,000

Depreciation recapture taxes on this $100,000 of left over profit, which is 25% of $100,000 = $25,000 taxes owed

----------------------------------------------------------------

(B) IRS says, nope, first we recapture depreciation and then take care of passive losses

Depreciation recapture tax on $150,000 out of that $200,000 profit from sale

remaining $50,000 gets offset from my $100,000 of suspended losses, so no taxes on remaining $50,000. What happens to $50,000 of passive loss still left?

So final outcome is only depreciation recapture taxes on $150,000, which is 25% of $150,000 = $37,500 taxes owed

----------------------------------------------------------------

Also, it makes me question if passive real estate investing is really worth it if rental income is only few hundredd dollara above mortgage payments? Leaving all this "adjusted cost basis" stuff asside and counting real money only ... seems like that $50,000 actual profit i made on sale of house, cost me $37,500 of taxes (assuming scenario B is the correct tax calculation), leaving me with $12,500 in my pocket from sale of the house. All the while making virtually tax free $5000 every year (as mentioned above, my expenses were $30,000 and rental income was $35,000 every year). So over a decade, i made $50,000 as rental income and pocketed additional $12,500 at the time of sale. So the house made me $62,000 over the decade.

considering i put $125,000 as downpayment, thats very poor rate of return. I might as well have put that $125,000 in S&P500 index

I might as well have lived in the house as primary residence. I would have been able to use that $10,000 deduction every year. And keep that $50,000 in my pocket from sale of house (since we are allowed to keep $250,000 of profit from sale of primary residence). It's almost the same return, but with no headache of dealing with tenants.

And yes, i presented an unrealistic scenario. Maybe a house will sell for higher value, but if real money is in sale of the property, then primary residence wins over investment property.

A passive real estate investor might be better to first own a primary home. And then get into passive real estate investing.

And i understand there are other ways to avoid tax like keep doing 1031 exchange until i drop and leave the house for next generation. Good for next generation, but in my life i never got to see real money out of that house (apart from few hundred dollars a month).

Dallas, Texas

0 Votes