Is Depreciation Recapture Tax not applicable after 8.5 years?

Question

Hello!

Quick question regarding depreciation recapture.  I was thinking about selling a two family house I own in Somerville, MA while my 2/5 year owner occupant tax exclusion still applied for half of the house.  I decided not to because I've been depreciating the rental portion of the house since 2011, and my CPA told me that the capital gains I would save would be offset by needing to pay a hefty depreciation recapture tax.  After 8.5 years of owning it, however, he said that I would no longer need to pay a depreciation recapture tax.

Is that accurate?  I haven't been able to find any info online to verify that, and I recently repeated the 8.5 year rule to an investor client of mine who looked at me like I had two heads.  Any help anyone may have would be greatly appreciated!

Dave Toelkes · Answer

The IRS will treat the sale of your two-family property as two separate transactions -- a primary residence sale, and, an investment property sale -- each with their own tax treatments.  For the primary residence property sale, if you meet the 2 of the prior 5 year tests, you may exclude the first $250K (per taxpayer) in profit from capital gains taxes.  For the investment property, you can use a 1031 exchange to (perhaps indefinitely) defer the capital gains and unrecaptured depreciation taxes if you acquire a qualified replacement property.

You can have your cake and eat it too.  No need to abandon the idea of selling your property if you have a compelling reason to sell.

Is there more to the conversation with your CPA that you have not told us?  For example, let's say you bought the property at the top of the market and property values subsequently dropped such that the investment property net sale proceeds is equal to or less than the adjusted cost basis for the investment property.  In this instance, you would not have any unrecaptured depreciation to be taxed.  Was anything like this part of the discussion?

Glenn McCrorey · Answer

@Dave Foster  Thanks Dave.  A lot of people don't think that far ahead but you know what they say about death and taxes!  People ask me what my exit strategy is and I just say "to die rich".

Dave Foster · Answer

@Evan Cochran, I think the corpse of your poor cpa will be laying in the street for a while to serve as a warning....

Sell the property, take the portion allocated to your primary residence use tax free.  Do a 1031 exchange on the half that was investment.  Defer all gain and depreciation recapture from that portion.

Tax free and Tax deferred - 100%  Like @?Dave Toelkes said its a nice way to double dip.

Linda Weygant · Answer

I am sincerely hoping that you misunderstood what your CPA said.  Such a rule does not exist and if your CPA is spreading this kind of misinformation, they should probably be sanctioned by their state board.

Lauren Speidel · Answer

@Evan Cochran If you qualify for the 121 Exclusion ( you must have owned and lived in the property as your primary for at least a total of 24 months out of the last 60) you can sell the property and exclude from gross income up to $250k in capital gain (per taxpayer, a married couple is 500k). You can then do a 1031 Exchange with the remaining portion. You would not only defer your capital gains tax but also your depreciation recapture liability. If you continue to 1031 Exchange throughout your lifetime, your beneficiaries will receive a step up in cost basis at the date of your death. It can be powerful long-term estate planning tool.

Combining the two strategies can be even more powerful. Keep in mind, it is important to discuss your particular transaction with your CPA, RE Attorney, and Qualified Intermediary.

Dave Foster · Answer

@Glenn McCrorey, You're right.  But it's not just the depreciation that goes away when you die.  It's also any gain at all.  Your property basis is "stepped up" for your heirs so they inherit as if they paid market value for it as of the day you died.

Not so much fun for you but a reassurance that you've done something good for them.  This is one of the main motivators behind a 1031 investors decision to defer until you die.  You get use of the tax dollars for your own investing throughout your life and then give the properties through your estate tax free to your heirs.

Glenn McCrorey · Answer

@Evan Cochran  Thanks for getting my little heart pitter pattering... I just sold a condo I have had 13 years (I rarely sell anything) but I think depreciation recapture is 25% unless you die while owning it, then it goes away or should I say it starts over at the new market value and your heirs pay if they sell someday based on what they value was established at your death and how much they depreciate it ... at least that's what I believe but welcome comments or corrections.

Jack B. · Answer

Yeah, his CPA has no clue what he is talking about. Honestly most I've worked with don't...

Carl Fischer · Answer

@Evan Cochran

I wish it was true about 8.5 years! Never heard of such a thing.

Is Depreciation Recapture Tax not applicable after 8.5 years?

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