Depreciation Recapture, Capital Gains, and Foreign Tax Credit

[df1976]

Q1. Does depreciation recapture put you in a higher tax bracket? For example: 

A married couple filing jointly has taxable income total (from wages and rental income) of $80,000, which puts them in a 12% tax bracket. They sell a rental property. The depreciation recapture on the sale is $20,000. Are they paying 12% on the $20,000 or do they get bumped to the 22% tax bracket, which results in paying taxes according to the 22% bracket on ALL of their income (wages, rental income, and depreciation recapture)?

Q2. Can you use foreign tax credit on depreciation recapture? For example:

A married couple filing jointly sells a rental property abroad. The depreciation recapture on the sale is $20,000 taxable at 12% = $2400. The capital gain (long term) is $100,000 taxable at 15% = $15,000. They paid $20,000 in taxes on this sale in the country where the property was located. They can claim $15,000 of Foreign Tax Credit on the long term capital gain tax, but can they claim another $2400 from the remaining $5000 on depreciation recapture?

Q3. Can you correct the cost basis at the time of sale if it was wrong on Form 4562? For example:

A married couple filing jointly has been taking depreciation on their rental property annually based on $200,000 cost basis in Form 4562. It now turned out that the actual cost basis was $350,000 (due to lack of documentation at the time of purchase) + $50,000 land value, so $400,000 total. They're planning on selling the property in the next couple of years. Even though it's a bummer they've been taking less depreciation than they could have, will they be able to use $400,000 purchase value to calculate their depreciation recapture and capital gain/loss? Is it wrong to continue using the same incorrect depreciation in the next 2 years for the ease of filing? Is there any requirement to correct Form 4562 if the cost basis turns out to be incorrect down the line?

Thank you!

[AmeliesUncle · Accepted solution]

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@df1976 wrote:

Q1. Does depreciation recapture put you in a higher tax bracket

 do they get bumped to the 22% tax bracket, which results in paying taxes according to the 22% bracket on ALL of their income (wages, rental income, and depreciation recapture)?

Q2. Can you use foreign tax credit on depreciation recapture?

They can claim $15,000 of Foreign Tax Credit on the long term capital gain tax, but can they claim another $2400 from the remaining $5000 on depreciation recapture?

Q3. Can you correct the cost basis at the time of sale if it was wrong on Form 4562?

For example:

A married couple filing jointly has been taking depreciation on their rental property annually based on $200,000 cost basis in Form 4562. It now turned out that the actual cost basis was $350,000 (due to lack of documentation at the time of purchase) + $50,000 land value, so $400,000 total.

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1) Yes, but only the 'extra' income is taxed at 22%.  The prior income is still at the 10% and 12% brackets.

2) Sort of.  The calculation is more based on the amount of foreign tax, not the specific amount of US tax on those specific items.  The software should do the calculations, via Form 1116.

3)  First, the Basis for depreciation is the LOWER of (a) Cost and (b) Fair Market Value when it was turned into a rental.  With that in mind, is the depreciable Basis incorrect?

If so, correct the Basis in the program now.    However, you need to change the "prior depreciation" to the amount that SHOULD have been claimed (the larger amount).

So the correct Basis will be used to report the sale of the property.  But unfortunately, there will be tax due to the gain from depreciation, even the depreciation that they mistakenly did not take.

4) If there was a mortgage on the foreign rental property, there could be Section 988 gains or losses, and I really doubt if TurboTax deals with that.  Many tax professionals don't even know how it works.


Due to the many issues you are asking about, I really think it will be in your best interest to go to a good tax professional that is experienced with such things.

[Carl]

You don't mention what country this property is in. Or did I miss it maybe?

Q1. Does depreciation recapture put you in a higher tax bracket?

It could, as recaptured depreciation is added to your AGI in the tax year of recapture (Usually the year you sell the property)

which results in paying taxes according to the 22% bracket on ALL of their income

The above statement (standing alone as copied by me) is wrong. For how tax bracketing works, see https://www.irs.com/en/articles/2022-federal-income-tax-brackets-rates-standard-deductions and read at least half of it to ensure you're clear on how it works.

Q2. Can you use foreign tax credit on depreciation recapture?

The foreign tax credit is based on qualified foreign taxes paid, regardless of why those taxes were assessed by the foreign taxing authority. It's also possible the credit may not be "dollar for dollar", as it depends on a few factors, including the foreign country where the property is located and what type of agreement (if any) the IRS may have with the foreign taxing authority of that country.

Q3. Can you correct the cost basis at the time of sale if it was wrong on Form 4562?

If you change any existing value of any depreciated asset in the Assets/Depreciation section, that will completely skew the depreciation history, as well as the current year's depreciation taken. Rnetal property and it's associated assets are depreciated based on the "LOWER" of what you paid for it when originally purchased, plus the cost of any improvements prior to placing it in service, *or* it's FMV on the date it was placed in service. Whichever is lower. It is not common for the FMV on the date placed in service to be lower. Therefore, the original purchase price is most commonly used for depreciation.

Your cost basis in the property is what you paid for the property when you originally acquired it, plus the cost of any property improvements you paid for, over the entire time you owned it. If the cost basis of all listed assets do not add up to that, then you can't and don't report the sale in the SCH E section of the program. Instead, you report the sale in the "Sale of Business Property" section.

It now turned out that the actual cost basis was $350,000 (due to lack of documentation at the time of purchase) + $50,000 land value, so $400,000 total.

I think you're math is wrong. The $50K land value is already included in the $350K you mentioned. What may be misleading you is the way your cost basis on the property itself is entered/displayed in the Assets/Depreciation section. On that screen for the property asset, you have a box labeled COST and another box labeled COST OF LAND. Here's the breakdown.

COST: What you paid for the property in full. This includes the land.

COST OF LAND: the amount in the COST box that is allocated to the land.

With those two figures you provided above, the program (not you) does the math and subtracts the cost of land (50K in your case) from the cost, ($350K in your case) and the program (not you) assigns a value of $300K to the structure, and it's $300K that gets depreciated over time.

If you did not enter the correct figures, then you have a problem that is not simple to fix by any stretch. You need professional help yesterday, if not sooner. Especially if your state taxes personal income.

Is it wrong to continue using the same incorrect depreciation in the next 2 years for the ease of filing?

When you sell the property, you are required to recapture and pay tax on the *higher* amount of actual depreciation taken, or the depreciation you should have taken; whichever is higher. heck, even if you didn't taken any depreciation at all, you're still required to recapture what you should have taken and pay taxes on it.