Depreciation Expense Impact on Tax for Rental Property

[Michelle Au]

My husband and I are deciding whether to sell our primary residence that have been rented out for 2 years or keep it as a rental unit. If we sell the unit now, it is still considered a primary residence (lived there for 2 out of the 5 years preceding sales) which will exempt us from capital gain ($250k for single; $500K for married filing joint). I know that we would still have to pay taxes (25%) on the depreciation recapture from the 2 years we held it as rental property.

I want to fully understand the tax impact if we keep it as a rental unit. We are currently breaking even on the property before depreciation expense (we are holding on to the property b/c it's in an area where the appreciation is high), can the "unused" depreciation expense be carryover as PAL to be applied against capital gain when we sell the unit later on?

Here are some facts:

1. The FMV when we starting renting out the unit is > initial purchase price

2. We expect the selling price in the future > FMV when we starting renting out the unit.

Am I thinking of this correctly?

1. The cost basis of the property would be our initial purchase price less accumulated depreciation

2. Taxable gain would be selling price less cost basis

3. Tax would include 25% on depreciation recapture

4. Remaining tax would be total taxable gain less depreciation recapture less PAL carryforward (from "unused" depreciation expense)

Alternatively, could I not depreciate the property (which i did not do for the past 2 years in error and need to file amendments) and file a Form 3115 (application for change in accounting method) in the year in which I sell the property to catch up and claim all the the missing depreciation all at once?

Thank you!

[Ashish Acharya]

@Michelle Au ,

Looks like you know what you are talking about.

If you are breaking even before the depreciation, the depreciation expense would create a net rental loss that can be deducted each year if your AGI is below 100k. You can deduct 25k of rental loss if you actively participate. If you AGI is > 150k, then the loss would be suspended. If your AGI is between 100 to 150, the 25k is phased out and get partial deduction until you reach 150k.

If your AGI is more than 150k, then those losses will be suspended (unless you qualify as RE professional) until when you sell the house and will offset your passive gain when you dispose. Also, remember that these suspended losses can use against any other passive income, does not have to be related to this house.

I know that you wanted to know if the suspended loss would eat you gain when you sold it, but it always better to plan in such a way to take the rental loss today and offset your ordinary income that is taxed at higher rate today than wanting to suspend the loss and later eat your capital gain from sale of the house.