Depreciation and Passive Accumulated Losses

[Sahil Rohra]

Hi,

Had a quick question to confirm I am understanding how passive activity losses and depreciation (and depreciation recapture works). 

Please see below hypothetical example. Assuming I bought the below property and sold at the end of the 5th year

Purchase Price: $325,000

Land Value: $50,000

Depreciable Basis: $275,000

Annual income for each year: $17,000

Expenses: $25K a year for each of the 5 years. Annual expenses are made up of:

-$10,000 Depreciation straight-lined (27.5 yrs)

-$10,000 Mortgage Interest

-$5,000 Prop Taxes

All losses have to be carried over due to income limit.

I then sell property for $400,000.

Over the 5 years, I have accumulated $85K in income, but have an accumulated loss of -$125K, so a net loss of -$40K (-$8K a year) that has been accumulated over 5 years.

Now that I sold for a gain, I would owe taxes on $125K ($400K-($325K-$50K depreciation reduced)). Now assuming I am taxed at the 25% cap rate of depreciation recapture, and a long term capital gains rate of 15%, I would owe $23,750 in taxes (25% of $50k depreciation = $12.5K + 15% on $75K appreciation from selling house = $11.25K in cap gains).

Questions are:

1.) Assuming all of the above is correct, after I pay back the depreciation recapture, I’m assuming I can use the        -$40K in net accumulated losses to offset the part of my capital gain totaling $75K, correct? So in this case I would only pay my 15% cap gains rate on $35K.

2.) Now hypothetically, if I still had left over passive activity losses left over after offsetting the entirety of the $75K in cap gains, what can I do with this? Can I offset capital gains from selling stock, offset dividends, etc?

[Michael Plaks]

@Sahil Rohra

You're on the right track, however the actual numbers depend on your total income. 25% is not the fixed rate of depreciation recapture, but the maximum/ceiling rate. If your marginal tax rate is 12% or 22%, you would pay 12% or 22% on depreciation recapture, not 25%.

Likewise you capital gains rate is not necessarily 15%. It can be 0%, 15%, 20% or even 24% - again depending on your overall income. 

Your Q1/Q2. Yes, you can use $40k of accumulated losses but they will go against your other income first, such as your W2. Which is actually better for you than applying it against capital gains.