Depreciation Recapture upon Sale that includes Personal Property

[Margaret Feit]

Hi All, 

I'm trying to wrap my head around planning for capital gains and depreciation recapture if I start to sell some appreciated property within the next few years. I'm also trying to determine whether to take accelerated depreciation when it's available to me, and what the longer-term ramifications might be. For the moment I am leaving 1031 considerations out of this.

Suppose this year I purchase a hot tub for my rental property for $5000. As personal property and not actually part of the house, I believe I can take accelerated depreciation for it this year to write off the entire cost. If I then sell the property next year for an overall gain, and the hot tub is transferred with the property but not listed separately on the sales contract, how would I record the sale of the hot tub for tax purposes? Do I have to list it as sold for its original purchase price or a reasonable current value (say $4000) and decrease the overall reported sale of the rest of the property accordingly? If so, that would trigger depreciation recapture on the hot tub, which seems like it would essentially wipe out any benefit I had from taking accelerated depreciation, right? And with a good chance that I could be in a higher tax bracket in the year that I sell, it seems like I could actually lose money by taking the accelerated depreciation.

Alternatively, could I write it off as sold for $0 (or essentially given away), since it wasn't listed in the contract, and the buyer will not likely be categorizing it as a separate item on their end? In that case, I would end up with a slightly higher capital gain on the property overall but no depreciation recapture on the hot tub, right? That seems like a win, but is maybe not allowed. 

While I know you can't give binding legal advise on a forum, can someone clarify for me how this sort of thing is typically done and what is generally accepted by the IRS?

[Michael Plaks]

@Margaret Feit

I did not see this post when you asked your question, hence the delayed response. 

ALL depreciation is a loan unless you do an exchange or die, and I don't recommend the latter, despite its tax benefits. 

Let's say you bought a property for $200,000 and are later selling it for $300,000. You will have $100,000 capital gain on the appreciation part. In addition to this capital gain, you will have depreciation recapture of all depreciation you have taken. If you did conservative depreciation and took $10k of it - you will have a depreciation recapture tax on $10k. If you took accelerated depreciation worth $40k - then you will have $40k of depreciation recapture.

In that regard you always, using your expression, "wipe out any benefit" of depreciation in the end, accelerated or not. 

Here is where it gets complicated. You can sometimes win this recapture game, due to one or both of the two factors: 

1. time value of money and 
2. difference in tax rates. 

The former means that even if you eventually return the exact amount of your tax savings, you get to use the money in between as an interest-free loan and repay it with the money devalued by inflation. The latter means that you sometimes get a depreciation deduction at a higher tax rate than your future tax rate on the depreciation recapture income. As in: save 30 cents on the dollar but then recapture only 20 cents on the dollar, pocketing the 10 cent difference. (Random numbers just for an illustration.)

Unfortunately, the rate difference can sometimes work against you: you may end up paying more taxes on the depreciation recapture than what you saved from the depreciation itself. It all depends on your tax situation that changes from year to year and on the tax laws that also change. I know this is not helpful, but it is true.

Assuming that your hot tub qualifies as a personal property, it will be depreciated differently from the building. There're several options, including 100% bonus depreciation in the 1st year. No matter which depreciation method you choose, you will need to allocate part of the sale price to the tub, using its fair market value at the time of sale, as correctly suggested by @Christopher Smith. You can only assign $0 if the tub becomes destroyed/stolen or otherwise worthless. (Unless you decide to cut the corners aka break the rules.)

Let's say that your $5,000 hot tub is worth $2,000 when you sell it. If you depreciated $3,000 of the $5,000 - then you have no gain, no loss and no depreciation recapture. If you depreciated the whole $5,000 - then you have $2,000 of depreciation recapture. You may even have a tax loss if you took slow depreciation but the tub lost a lot of its value, although this is a rare scenario.

The only way to make an informed decision on accelerated depreciation is by carefully considering your overall tax situation and your plans for the future. Even then, it's somewhat of a gamble on the future.