Depreciation recapture

[Payman A.]

Hi all.  I'm a bit confused on this issue as I read about depreciation recapture being taxed as "ordinary income" then I see mentions of a "flat 25% rate".  I have a 3 part questions:

- So will the rate depend on your tax bracket like ordinary income or is it a flat 25% tax? (asking because I'm in a low tax bracket, not because I'm worried about paying a higher than 25% rate)

- If a 1031 is used to exchange down, how is the depreciation allocated?  (are the deferred and payable portions directly proportional to the values of the relinquished and replacement properties?)

- Is depreciation recapture in fact avoided entirely if an investment property is sold at a loss or breakeven?

Thanks in advance,

Payman

[Naseer Khan]

@Payman A. The rate for depreciation recapture is 25%, regardless of your ordinary income tax rate. 

Generally, the depreciation recapture does transfer in a 1031 exchange, but there are several factors to take into account and you would need to talk to a 1031 expert for that. 

If you sell the property below your adjusted cost basis, which takes depreciation deductions into account (depreciation deductions reduce your cost basis), then you will not have to pay the recapture tax. 

[Payman A.]

Hello Naseer and thank you for your reply.

I had confused myself (and gotten my hopes up) by not considering the "adjusted cost" for the scenario.  

[Account Closed]

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[Account Closed]

@Naseer Khan  I noticed you've answered several questions about depreciation recapture in this forum, so I wanted to ask: Do you know what's the recommendation for multi units that are also owner occupied? I am occupying one unit in my property and I'm renting out the other two.I'm reporting the rental income and expenses on my tax returns. Is it recommended to claim the depreciation expense on the two rental units? If so, how would the amount be calculated?

I'm planning to keep this property as a very long term investment, but in case of a sale, will I be taxed at 25% on the depreciation recapture?

Will the depreciation decrease my base, even though it is also a primary residence?

Much appreciated!

[Dave Toelkes]

@Account Closed

You have a multi-unit property consisting of three separate dwelling units.  Two of the units are rentals while the third is your primary residence.  For tax purposes, the IRS will treat your tri-plex as three separate and distinct units.  Each of the rental units should be depreciated as individual properties  rather than combined into one property.  You say that you are reporting rental income and expenses on your tax returns.  Are you reporting your rental activity on Schedule E?

On your Schedule E, you report two separate rental properties.  If all three units are approximately the same size, then 1/3 of your mortgage interest, property tax, and hazard insurance can be claimed on Schedule E for each rental property.

Yes, you do want to claim depreciation.  If you don't take a depreciation expense, then when you sell, the IRS will tax you on the depreciation you should have taken anyway.  You can not depreciate your primary residence unit, nor, can you depreciate cost of the land your property sits on.  

This is just a quick overview.  Suggest you consult your own CPA or tax adviser for specific guidance as it may relate to your unique circumstances.

[Account Closed]

@Dave Toelkes Thanks for the very detailed reply.

If I report on schedule E as three different properties, my understanding is that I should only claim one third of the depreciation on each of the two rental units, but not the one I'm occupying. Is this correct?

Just to confirm, I read in other places in the forum that if I occupy the property for at least 2 years, I could still sell without being taxed on any gains in the property as long as it is below the $250K limit. However, I will be taxed on the total depreciation I took at 25%?

Also, in this case, will you use 27.5% years? Also, how will I estimate the cost of the land vs the cost of the improvement (the building)?

Many thanks!

[Dave Toelkes]

@Account Closed

You will report your two rental units on Schedule E.  Your residence unit is not a Schedule E property.  You cannot claim depreciation on your residence unit, nor can you depreciate the value of the land.

Remember, the IRS wants you to report your tri-plex as three separate properties:  two rental properties and one primary residence.

Here is one way to approach this question.  Look at your local tax assessor's property tax notice and see how much of the property value is allocated to the land and how much to the dwelling structure.  Divide the assessed value for the improvements by the total property value, then multiply by your purchase price.  That result is the cost of the improvements. Divide this number by 3 to determine the cost each separate unit (dwelling structure).  Now set up a separate depreciation schedule for each rental property using the cost of the each unit's dwelling structure for your depreciation basis.  For residential rental property, the class life for straight-line depreciation is 27.5 years.  

If you own AND occupy your residence unit at least two years of the five years prior to sale, you qualify to exclude up to $250K of capital gain from taxation.  The excluded gain is only the gain on your residence unit not the entire property.  In this scenario, you allocated one-third of your purchase price to your residence unit.  That amount is your initial cost basis for calculating your capital gain.  If you sell the entire property, then one third of your net sale proceeds minus one-third of your purchase price is your capital gain on the sale of your residence unit.  The other two-thirds of your sale profit is taxable from the sale of your rental units.  

As far as depreciation recapture is concerned, you are taxed on the depreciation you took (or should have taken, whichever is higher) for the rental units.  This tax is not avoidable if your sell the rentals in a taxable even.  If you never used your residence unit as a rental, then there is no depreciation to recapture on your residence unit.

[Account Closed]

@Dave Toelkes Thanks for a very detailed response. Very helpful! I'll send this to my CPA for reference.

Have a nice weekend!

[Dave Toelkes]

@Account Closed

If your CPA needs this as a reference, then you should consider getting a new CPA

[Steven Hickox]

Dear David:  Just to answer your question about depreciation recapture when you trade down in value in a 1031x.  The general thinking is that you will be taxed on the trade down in value at the highest rate possible or at recaptured depreciation rates (limited of course by the actual amount of depreciation recapture in your case).  For example if you sell for $1M and you have a basis of $500k and $250K of accumulated depreciation and you trade down in value to $650k, then $250k will be taxed at recaptured depreciation rates and $100 will be taxed at long term capital gains rate.  Clear. Steven Hickox.

[Dave Toelkes]

@Steven Hickox,

If the initial cost basis was $500K and total depreciation taken was $250K, then the adjusted basis in the property is $250K. If you do a 1031 exchange, selling as the relinquished property for $1 million gives you a capital gain of $750K allocated as $500K due to appreciation and $250K due to depreciation.  When a replacement property is acquired for $650K, then the relinquished property's cost basis of $250K becomes the new cost basis for the replacement property.  The accumulated depreciation transfers to the replacement property.  Only $150K of the $500K in capital gain due to appreciation transfers to the new property, giving the exchanger $350K in cash boot, taxed as a long term capital gain.

Just how I see it.  I will defer to the 1031 experts on this site for a better response if I am incorrect.

[Adam Nishikawa]

Here is the only worksheet I have with me right now, hope it helps. 

[Dave Foster]

@Payman A., the guys have been answering questions for your CPA and doing a great job. I second what Dave Toelkes said - if you're having to come to Bigger Pockets for this kind of info and you have a CPA on your case you need a new CPA.  

@Steven Hickox and @Dave Toelkes, are representing two sides of the depreciation recapture argument and they're both right.  Reputable CPAs and QIs fall on both sides of this issue when addressing depreciation recapture and boot.  There are those who insist that you recapture depreciation first when taking boot.  There are those that argue that since basis is carrying over that gain is counted as boot first.  The law is vague.  You're CPA will need to stand behind your decision. Another reason to make sure you've got a good CPA.

[Dave Toelkes]

@Dave Foster,

I suppose the path to take on the depreciation recapture question depends on the exchanger's tax bracket rate.  

If my tax bracket rate is higher than 25%, then paying tax on the unrecaptured depreciation allows me to add that amount of unrecaptured depreciation back to the depreciation basis where I can begin depreciating it again on a new 27.5 year schedule.  I can see the advantage of paying a maximum 25% tax now to offset future rental income that would be taxed at a much higher rate.  

For those in the 25% bracket and lower, there is no immediate advantage to paying a higher tax on unrecaptured depreciation than would be paid on long term capital gain.

[Mike Richards]

Depreciation recapture tax not always 25%????

Unrecaptured sec.1250 gain is subject to the 25% rate – only if you are in the 25% or higher bracket. Otherwise it will be taxed at the lower rate you are in.

Schedule D worksheet line 38 = line 37×25%.

Line 37 COULD be $0.

Line 37 is figured after removing 75,300 (married filing jointly 15% bracket).

These are numbers for 2016. Did the law change?

[Monica Marusic]

As far as depreciation recapture is concerned, you are taxed on the depreciation you took (or should have taken, whichever is higher) for the rental units. This tax is not avoidable if your sell the rentals in a taxable even.

I'm glad I came across this thread @Dave Toelkes.  I'm a new investor and just filed my taxes, I chose not to depreciate my 1st rental, which I bought in oct 2016 because I thought that way I would not get hit by it later.  Could I do the depreciation for last year and this one the next time I file taxes?  Thanks!

[Paul Allen]

@Monica Marusic You could file a superseded return before April 18 and fix it now. Or you could file an amended return after April 18 to fix it (as long as you have not filed the wrong way twice - which you haven't yet).

[Monica Marusic]

So I could do it now even if I already received my return from both state and federal?

[Paul Allen]

You would need to paper file it. I would write "Superseded Return" in red across the top of it and include copies of your ID. Maybe even a cover letter explaining why you are filing a superseded return. Nothing long and fancy just one or two sentences explaining your purpose. Make it easy on the agents receiving the returns to understand what is going on. Especially your Virginia return. The folks in Richmond seem a bit overwhelmed (again) this year.

[Paul M.]

So we are sure that depreciation taken in the past is taxed at 25%, not ordinary income tax rates?   Where does the ordinary income tax rumor, if it is that, come from?   Are there other types of assets where depreciation recapture is taxed that way?   It is definitely something I've seen in my life, somewhere...

[Basit Siddiqi]

@Paul M.

Depreciation recapture is taxed at a maximum tax rate of 25% for federal purposes. 
If your marginal federal rate is 12%, it will be taxed at 12%

State tax rates still apply.

[Daniel Dietz]

@Basit Siddiqi or others 'in the know', 

Say for my regular taxable income (before cap gains or recapture taxes)  I am 10K below the threshold that takes me from 12% to 22%. 

I now have 20K of long term cap gains and 20K of depreciation recapture. I assume that 30K of that which 'goes over the bracket threshold' around 72K is going to be taxed in the 22% rate and change from 0% to 15% for capital gains?

Thanks, Dan Dietz

[Basit Siddiqi]

@Daniel Dietz

The tax system we have is progressive so even if you go above a certain bracket, only the income above the bracket is taxed at the new rate. Not all your income.

Therefore, I do not follow how $72,000 will be taxed at 22%. I see 10,000 being taxed at 25%, 10,000 being taxed at 22% and the rest at either 15%, 12% or 10%