Depreciation: when do I get credit for initial purchase?

Question

I've Learned a ton about accounting lately, but I just can't seem to figure out depreciation.

I bought a rental property for $25,000 in 2012. I was paying back $500/ month at 4% interest to a private investor. I sold the property earlier this year for $38,000.

When I was working on my taxes for 2012 I learned that I couldn't deduct the principle amount for the loan, only the interest portion. I fully understand that now, but didn't at the time.

What I haven't ever figured out is the depreciation process for the initial $25,000. I understand that I'm required to spread that cost out over 27.5 years. So, as I understand it, I get a deduction of $909/ year  ($25,000/ 27.5 years). I sold the house this year for $38,000. SO, I have deducted $909 for approximately 3 years. Total depreciation of $2,727 (909/ year x 3 years). What happens to the other $22,273? (25000 initial - total depreciation of 2727)... when do I account for that?

Also, I have read that depreciation accounts for the wear and tear of a property... It wears out over time in theory.

I've also read that depreciation is accounting for the initial cost, spread out over 27.5 years, instead of an expense all deducted in one year.

Which one is it, or am I missing something?

Most people explain that depreciation is an awesome tax benefit. I feel like I got shafted on my taxes for 2012. I was charging $700/ month for rent, paying $500/ month for the loan, and $100/ month for insurance and property taxes. I put $100/ month in my pocket and handed out the other $600, but was taxed on $700/ month income. I got deductions for property taxes, insurance, and interest paid as well as 1/12th of the $909 depreciation. All told, I profited $100/ month, and owed taxes on approximately $400/ month. I paid more in taxes that I made. How is this a good thing for taxes in the short term?

John K. · Answer

First of all, you probably want to consult an accountant, also the 27.5 is a rough number - but there are actually IRS tables you should reference to get the exact amount.

Depreciation - the initial $25,000.  You need to first figure out what the land value is vs. improvements value.  Look up your property on the local tax records database for assessment values.  In 2012, lets say that when you purchased it it was assessed at $32,000, $5,000 for land, $27,000 for the building.  You would take the $27,000 / $32,000 =   .84375 (ratio of improvements to total value), then .84375 x $25,000 (purchase price) to get a depreciate basis of $21,093.75.  The $21,093.75 would be what you divide by 27.5 to get your annual depreciation amount, ie: $767.04 annually or  $63.92 a month.  You can never depreciate the land, only improvements.

Using your numbers, the $22,273 is just the adjusted basis - so you basically have a gain of the $2,727 since you sold it for greater than purchase price.

Most people explain that depreciation is an awesome tax benefit. I feel like I got shafted on my taxes for 2012. I was charging $700/ month for rent, paying $500/ month for the loan, and $100/ month for insurance and property taxes. I put $100/ month in my pocket and handed out the other $600, but was taxed on $700/ month income. I got deductions for property taxes, insurance, and interest paid as well as 1/12th of the $909 depreciation. All told, I profited $100/ month, and owed taxes on approximately $400/ month. I paid more in taxes that I made. How is this a good thing for taxes in the short term?

Your numbers (in a nutshell) cash flow:Revenue: $700Mortgage: ($500)Insurance & Taxes: ($100)Cash Flow: $100.00

net income (taxable)Revenue: $700Mortgage interest ($400) (I guessed)Insurance & taxes: ($100)Depreciation: ($63.92) (I used my rough number)Taxable Income: $136.08

Using my numbers above, you should have only been taxed on $136ish, not the $400.

disclaimer: not a CPA, so you probably want to consult with one.  Might be worth re-filing your old tax returns to get the tax benefits.

Dave Toelkes · Answer

@Cameron Price

I think you have gotten confused by the responses you have received.

Let me try to simplify the question and the answer.

You bought a property for $25K and sold it three years later for $38K.  During your holding period, you took $2727 in depreciation.  Your question is how will the taxes work?

You have $13000 in capital gain due to appreciation ($38K - $25K).  Plus you have $2727 in capital gain due to depreciation.  The capital gain due appreciation will be taxed as a long term gain at the capital gains tax rate applicable to your marginal tax bracket.  If you are in the 15% tax bracket or below, then your long term capital gains tax rate will be 0%.  If your marginal income tax bracket is at least 25% up to 35%, then your long term capital gains tax rate will be 15%.  If your marginal income tax bracket is higher than 35%, then the long term capital gains tax rate will be 20%.  So your capital gains tax on $13000 in appreciation could be as low as $0 or as high as $2600.

For the depreciation that did not really happen, the depreciation that you took is taxed at a maximum of 25%.  The rest of the purchase price that you did not get to depreciate is not deductible, but it is not taxable income either.  You got that money back when you sold the property.

Now looking at your numbers, you borrowed $25000 and paid back $10188 ($283/mo for 3 years).  So on the sale of the property you put $23188 from equity in your pocket disregarding any sales commission or other selling expenses.  On this amount your tax bill for the profit plus unrecaptured depreciation could be as low as $682 in the 15% tax bracket.

When you consider that you got $3600 ($100 per month using your numbers) in cash flow from the property and then put another $23188 in your pocket at settlement, is the tax bill really that bad? If you still think it is, then consider that your tenants essentially paid your loan and paid for all the expenses of ownership.  It was really the use of your tenant's money that put that $26788 in your pocket.

Do you really want to focus on the little bit of income tax you had to pay on your rental income over three years, or, does the total after tax income in your bank account look so much better?  Is rental property looking better now?

When you look at the big picture, I think you made out like a bandit.  Instead of just one property, what if you accomplished the same thing with five properties, ten properties, or even more?  What if your tenants bought you five or six income producing properties over 15 to 20 years, then still paid you rent on those free and clear properties for the rest of your life?

Linda Weygant · Answer

@John K. has the nuts and bolts of it essentially correct and I agree with his advice that you should have a CPA knowledgeable in REI take a look at your prior year returns.  If you don't want to do that, I definitely suggest that you have a CPA prepare this year's return as there will be some extra complications with the property sale and depreciation recapture.

Essentially, you get the "credit" for that $22,273 in the year of sale as that is subtracted from the sales price to reach your capital gain amount.

Dave Toelkes · Answer

When you repay a loan, a portion of your monthly payment is interest on the loan, and a portion of your monthly payment reduces the outstanding balance on the loan.  The $283 came from your numbers.  You said your monthly payment to your lender was $500 per month and that (on the average) $217 of that was interest.  This leaves $283 of your monthly payment that went towards the loan balance.  Reducing the loan balance increased your equity.

Your capital gain is your net sales proceeds minus your cost basis.  Depreciation is an adjustment that reduces your cost basis, so YES, the amount of depreciation you took is part of the total capital gain.  You are not paying taxes on the depreciation, you are paying taxes on the income that was not taxed because you claimed a depreciation expense.  If a property wastes away to nothing, then you are allowed to offset your taxable rental income by the amount that the asset wasted away.  In accordance with the rules, you claimed a depreciation expense that reduced the amount of rental income that was really taxed.  Because the depreciation did not really occur (you sold the property for more than you paid for it), the government wants you to pay taxes on the income that was offset by the depreciation expense.   That amount of income is the same as the amount of depreciation you took.

This is one of my old posts, written when different different capital gains rates were in effect, but maybe it will help clarify how depreciation recapture works.

https://www.biggerpockets.com/forums/104/topics/25...

If you still have questions, just add to this thread.

Jeff B. · Answer

Depreciation is an accounting problem every April 15 in the States.  It's entered on your Sch E form - - forget entries in your Quickbooks.

Most common forms are Straight Line(SL) and Double Declining Balance(DDB) and

• buy and hold investors will want SL to reduce your exit game Depreciation Recovery  expenses.
• short term holders (aka less than 7 years) will want the DDB to maximize yearly profits.

There are tables online for both methods, but recommend a good CPA calculate this and give you the amortization table printout for each and every property as you'll need it when each is sold.

Cameron Price · Answer

@Dave Toelkes

I understand the capital gains on the 13,000.

Its the other part that confuses me to no end.

Where did 283/ month come from. I paid 500/ month.

I have a civil engineering degree and cant figure this out... why is this so hard!? Lol.

I know I came out good in the end, but my mental wiring wont let get by with not understanding this..

So capital gains are due on depeeciation I deducted? How is this right? If depreciation is the accounting for the money I already paid, why am I being taxes on accointing for it now?

Forgive my ignorance man. I'm trying hard, but this is whipping me.

I'm about to binge on youtube videos about real estate depreciation/ accounting.

John K. · Answer

If you purchased on January 1st of year 1, and Sold December 31st, with your $3000 you would be taxed at a higher rate since it was depreciation (again, IRS tables are used for actual amounts so it would vary depending on months you purchased/sold it).  Then your $13,000 would be a capital gain. Again, consult a CPA.

Regarding your other question, your interest seems low - you must have done a shorter term mortgage.  Typically with a 30 year (or 25 year), the numbers work out better.  Everyone has their opinion on financing and leverage and it's different in every situation.  I personally would never buy a property that I was taxed on $336 a month and only pocked $100.  My criteria is targeting net (taxable) income of ~$200-$300, and then cash flow of $700-900/month.  It's all just a big numbers game.

Cameron Price · Answer

Lightbulb moment! This is beginning to make sense!

Would you mind throwing some numbers to it to solidify this in my mind?

So for simplicity's sake, use these numbers:

Pirchase price: $25,000

Land Value: $5,000

So, depreciable amount: $20,000.

Lets pretend that I depreciated $1,000 a year for 3 years.

Sell price: 38,000

What does depreciation recaptire and capital gains look like?

Cameron Price · Answer

Thanks for such a detailed respone!

A couple things to add. I do have a CPA that handles my taxes. I gave him all the numbers and just wrote a check... my numbers in this example were my understanding, not actually whats on my returns as it was greek to me :) Thats why I 'm trying to understand.

From my records, the interest I actually paid was $2600 for the year, so $217/ month of my payment was interest. Your depreciation explanation helped a lot. That makes a lot of sense.

So more like:

Revenue: $700

Mortgage interest: $200

Insurance and Taxes: $100

Depreciation: $63.92

Taxable Income: $336.08

So, I still paid taxes on $336 and only pocketed $100. Stil doesnt seem advantageous on my taxes. Does it usually not make sense (tax wise) to pay off property quickly?

Again, thanks for taking the time to respond this in depth. I'm learning so much from this place and people like you who stop to help the next man.

Depreciation: when do I get credit for initial purchase?

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