Often an incidental military landlord gets surprised by depreciation recapture when the rental property is sold. This can be due to several reasons. One is that the taxpayer expects to have capital gains excluded from taxation and he or she doesn’t know about depreciation recapture. Another common reason is that the taxpayer, for whatever reason, didn’t depreciate the structure/building/house as was allowed, so there isn’t an expectation that depreciation recapture applies (it typically still does). Let’s explore what depreciation recapture actually is and how it impacts taxes on the sale of residential rental property, and if it can be avoided. But first let’s talk about depreciation.
I try hard to be accurate when I write, but when subjects are simplified and generalized they often aren’t as precise as they can be. Stuff is left out. Don’t take this article as a perfect explanation of this subject matter or as specific tax advice for your tax situation. This article can help you understand depreciation recapture better.
Depreciation is allowed in the tax code for real and tangible property that can be expected to last more than a year. This property is property that in theory can be worn out over time and thus lose value over time. Depreciation is supposed to account for that loss of value. From a tax perspective land is not viewed as being property that can be worn out, so it cannot be depreciated. When you depreciate residential rental property land should not be part of the depreciation, however this is a common depreciation error.
Depreciation rules are complicated, but for this discussion we are focused on residential rental property that is used as a long term rental. The concept works with other types of property, but there can be additional rules that apply. Residential rental property (long term rentals) have an asset life of 27.5 years, so they are depreciated over 27.5 years. If your starting value for depreciation (the basis) is $27,500, then each full year the property is in service you get a $1000 deduction from your income, thus reducing your tax liability.
Depreciation is really helpful for landlords to reduce tax liability and in some cases the end result is a loss from a tax perspective. This may mean that the landlord essentially has a profit that isn’t being taxed. Nice, right? Unfortunately that often comes at a price down the road.
If you sell that property at a loss compared to what you purchased it for (after deducting the depreciation from the basis. We’ll discuss that in a moment), then you don’t need to worry about that depreciation impacting your taxes when you sell the property. After all, the value of the property did go down, the reason for depreciation. But what we typically see in residential rental real estate on a sale is a gain. This means the property didn’t go down in value, so the IRS and Congress basically want you to make up for the tax advantage of depreciation when you sell for a gain. While it is not exactly like paying back the tax benefit for the depreciation you have taken (the numbers may not equal out), it is an easy way to view what is happening with depreciation recapture.
Depreciation recapture applies for depreciation taken or allowed. Sometimes taxpayers (including unfortunately some with the bad advice of tax preparers who should know better) will just not take depreciation to simplify their tax return and to avoid depreciation recapture. This is a bad decision unless you like paying more taxes than you are required to pay. If you don’t take depreciation but it was supposed to be taken or even if it was just allowed, the tax code requires depreciation recapture to still be paid on the depreciation you should (could) have taken. So not depreciating means you don’t get the tax benefit of depreciating, but you still pay the taxes for depreciation recapture. The tax code requires you to pay depreciation recapture even if the capital gains is excluded from taxation.
That isn’t the only provision in the tax code that is designed to make it more likely that you’ll pay depreciation recapture on the sale of a residential rental property. Another, is in how you calculate the basis when you sell the property. The starting basis is basically the costs of acquiring a property. Please note there are rules on what costs go into basis and what costs do not go into basis. We are not covering exactly how to detemine basis in this article, but are discussing basis in a simplified manner. For residential rental property there is what you call depreciation basis and land basis. Certain things change basis and when that happens it is called adjusted basis. For a rental property converted from a primary residence, the basis for depreciation starts as either the adjusted basis or the fair market value when the property is placed in service as a rental. The tax code requires that depreciation reduces the basis.
Let’s say you started with a basis of $100,000 and ignore all other factors for the adjusted basis calculation. If there is no depreciation and you sell the property for $100,000 then there is no profit, so no taxes (again we are ignoring other factors, selling expenses in this case would cause a loss).
But what if you depreciated or were supposed to depreciate $50,000? Now your basis when selling is: $100,000 – $50,000 = $50,000. Now the gain is: $100,000 (sales price) – $50,000 (adjusted basis) = $50,000 gain. A $50,000 gain when you didn’t sell at a profit. A $50,000 gain that is all depreciation recapture. You have to allocate to depreciation capture before you allocate to long term capital gains.
Let’s say that you sold the property for $150,000 instead. Then your gain is: $150,000 (sale price)- $50,000 (adjusted basis) = $100,000 gain. A $100,000 gain of which $50,000 is depreciation recapture. $50,000 would be long term capital gains. Again, we’ve ignored other inputs for simplicity.
The tax code refers to depreciation recapture as “unrecaptured section 1250 gain”. Under current law this gain is taxed at your “regular” tax rate, but with a max tax rate of 25%. If the property was owned for at least a year and a day, then the “regular” gain is taxed at the long term capital gains tax rate. This is typically lower than the taxpayer’s marginal tax rate and the max long term capital gains tax rate is 20%. You have probably noted that 25% is higher than 20%, which is one reason why many taxpayers don’t view depreciation recapture in a very favorable light.
Estimating Depreciation Recapture
A good practice on the sale of rental property is to estimate income taxes that may be owed due to the sale and if it is viewed as significant, then to pay the taxes shortly after the sale. This will eliminate or reduce the possibility of penalties and interest if the taxpayer waits until the tax return is filed. This is situational, so penalties and interest may or may not apply if taxes are not paid upon the sale of the property.
There is a simple way to roughly determine the gain of depreciation recapture. First, add up the depreciation already taken and estimate how much you will have taken in the current tax year prior to the sale. Add those two numbers together. This will give you the estimated total depreciation taken.
To determine the worst case tax liability due to depreciation recapture take 25% of the estimated total depreciation taken and that is the worst case amount. So if the depreciation was $100,000 then depreciation recapture is $100,000 and worst case taxes due to the depreciation recapture is $25,000. Most folks will be lower than that. To get a more precise estimate you’ll need to project the actual tax return results.
Don’t forget that if the state the rental is located in has an income tax, the income from the rental is sourced to that state. You’ll need to determine if there is a filing requirement for that state even if you are not a resident. If it does and you do, then you’ll want to estimate the taxes due to depreciation recapture for the state too and possibly your state of residence. Not filing non-resident tax returns when required is a common military family tax error. Here is an article that talks about when there may be a requirement to file a tax return as a non-resident. Note if the rental property is in a state that isn’t your state of residence, it is possible that both the non-resident state and your state of residence will view the gains and depreciation recapture from the sale as taxable. In that scenario your state of residence will typically give you a tax credit for income taxes paid in another state.
If you have capital gains excluded from taxation, then that is all you have to worry about. If the remaining capital gains is taxable you’ll want to estimate the taxes for that before determining if you should make estimated tax payments and how much those payments should be. The IRS has information on long term capital gains taxes here.
Correcting Depreciation Errors
Often when a taxpayer learns of depreciation or depreciation recapture they realize that depreciation was not taken. Or that depreciation was taken incorrectly (like land depreciated). The situation can be fixed, however as you might expect, there are rules on how to fix depreciation errors. It is NOT correct to just start depreciating correctly “late”, on your current year tax return. More is required. If you filed more than one tax return incorrectly for depreciation (2 plus years), in many but not all, scenarios it is NOT correct to file amendments (this includes not depreciating and when land was depreciated). In those scenarios the IRS requires that you file Form 3115, A Change of Accounting Method. In the case where depreciation was not taken, filing this form will typically save the taxpayer from the substantial negative impact that depreciation recapture can cause .
Form 3115 at first glance may appear to be long, but simple. It is not simple. You might think that tax software will ensure that you file it properly. You would be wrong. The form is intended to cover well over 200 different types of changes. And among those changes can be different requirements within each type of change. Not only do you need to follow the form instructions (and the tax code) to fill out this form, but multiple revenue procedures are used to fill out this form. Not only do you fill out the form, but there are a variety of required attachments and which attachments are required depends on the nature of the taxpayer’s specific situation. If that doesn’t convince you that it may be worth hiring a tax professional to correct depreciation errors then consider this: not only does this form get filed with your tax return, but a copy of this form needs to be mailed to an IRS department that specifically handles and processes these forms.
Does all this mean that you can’t correctly file this Form 3115 on your own? No, you might file it correctly. However, I recommend you hire a tax professional with expertise in this area if you need to file Form 3115 and in general to correct depreciation errors.
Can depreciation recapture be avoided?
Depreciation recapture due to the sale of a residential rental property can be avoided and it can be deferred. But the available methods have negatives.
You can avoid depreciation recapture by selling at a loss. That isn’t usually preferred and often neither is the other method, which is to die. Your heirs inherit property with a stepped up basis to fair market value. The property can then possibly be sold without any gains, which means no capital gains taxes, including depreciation recapture.
Often taxpayers don’t want to employ these two methods to avoid depreciation recapture, so instead they choose to defer depreciation recapture. The go-to-method to defer depreciation recapture and capital gains is to do a like-kind exchange or 1031 exchange. The gains and depreciation recapture can be rolled into a new property bought after selling the original property (there is also a reverse like-kind exchange). A 1031 exchange needs to go through an intermediary and be set up before the sale. Properties in a 1031 exchange have to be investment properties.
That’s it folks, depreciation recapture in a nutshell. A rather big nutshell.