How to handle depreciation carryover when you sell Rental property?

[EnergySaver29]

I have been using TT for years. We have a second home, that gets rental income during summer months. We have had this property for 10+ years. For each of the years, total expenses + depreciation exceeds the income on the property. We notice that TT has been carry forwarding Depreciations (that we could not take). As of now we have accumulated $100k+ carryforward depreciation (shows up on line #18 of TT's Schedule E worksheet) accumulated. I am guessing TT chose to Carry Forward depreciation instead of taking full depreciation and Carry Forward the net losses of expenses. 

Now we are selling the property. So a few questions - 1) why did TT chose to carry forward depreciation instead of carry forward losses (or are they same, or difference as far as IRS is concerned)? 2. In filling the 4797 while selling, will the carry over depreciation appear as PAL carry over?, 3. Assuming yes to #2, how/where does IRS know that we have carry over depreciation accumulated?

[Critter]

 I am guessing TT chose to Carry Forward depreciation instead of taking full depreciation and Carry Forward the net losses of expenses. The program is following the IRS rules on this subject.

Now we are selling the property. So a few questions - 1) why did TT chose to carry forward depreciation instead of carry forward losses (or are they same, or difference as far as IRS is concerned)?  Vacation home rules require the separation as they are not the same even though they may look that way.  

2. In filling the 4797 while selling, will the carry over depreciation appear as PAL carry over?  The non deductible  Sch E expenses are added to the basis when selling.

3. Assuming yes to #2, how/where does IRS know that we have carry over depreciation accumulated?  From the prior year Sch E forms. 

[Carl]

I have been using TT for years. We have a second home, that gets rental income during summer months. We have had this property for 10+ years. For each of the years, total expenses + depreciation exceeds the income on the property.

It is "extremely" rare for residential rental real estate to ever show a "taxable" profit on paper at tax time - especially if there's a mortgage on the property. Usually, the mortgage interest, property taxes, insurance and the depreciation you are required to take by law, will exceed the rental income received. Add to that other rental expenses and you're practically guaranteed that deductions will exceed the rental income each and every year.

We notice that TT has been carry forwarding Depreciations (that we could not take). As of now we have accumulated $100k+ carryforward depreciation (shows up on line #18 of TT's Schedule E worksheet) accumulated. I am guessing TT chose to Carry Forward depreciation instead of taking full depreciation and Carry Forward the net losses of expenses. 

TurboTax doesn't "choose" that. It's what's required by law. Once your rental deductions and expenses reduce the taxable rental income to zero, all remaining losses are required to be carried forward. So you'll note that your carry forward losses just get bigger with each passing year.

Now we are selling the property. So a few questions -

1) why did TT chose to carry forward depreciation instead of carry forward losses (or are they same, or difference as far as IRS is concerned)?

All losses get carried forward. With depreciation though, when you sell the property you are required by law to recapture that depreciation in the year you sell the program. That recaptured depreciation will be taxed anywhere from 0% to a maximum of 25%.

2. In filling the 4797 while selling, will the carry over depreciation appear as PAL carry over?,

In the year you sell, all depreciation is recaptured and taxed, period. One way to look at it is to say that your cost basis in the property is reduced by the amount of depreciation, thus increasing your taxable gain on the sale. (or reducing your loss if you sell at a loss.)

So after depreciation reduces your cost basis, your taxable gain is figured by subtracting that adjusted cost basis from your sales price.  Next, any carry forward losses are subtracted from that gain, thus reducing the amount that is taxable. Finally, if the subtracted losses reduce your taxable gain to zero, then (and only then) are any remaining losses deducted from other "ordinary" income.

3. Assuming yes to #2, how/where does IRS know that we have carry over depreciation accumulated?

Because you've been reporting your depreciation and carry over to the IRS on IRS Form 4563 as well as the form 8582 which is filed with the SCH E each year.

Basically, assuming this property was still classified as a rental at the time of the sale, if you just work the sale through the SCH E section of the program, then the program will take care of depreciation recapture and carryover's "for you". Just follow the guidance below.

Reporting the Sale of Rental Property

If you qualify for the "lived in 2 of last 5 years" capital gains exclusion, then when prompted you WILL indicate that this sale DOES INCLUDE the sale of your main home. For AD MIL personnel who don't qualify because of PCS orders, select this option anyway, because you "MIGHT" qualify for at last a partial exclusion.

Start working through Rental & Royalty Income (SCH E) "AS IF" you did not sell the property. One of the screens near the start will ahve a selection on it for "I sold or otherwise disposed of this property in  2018". Select it. After you select the "I sold or otherwise disposed of this property in 2018" you continue working it through "as if" you still own it. When you come to the summary screen you will enter all of your rental income and expenses, even it it's zero. Then you MUST work through the "Sale of Assets/Depreciation" section. You must work through each individual asset one at a time to report its disposition (in your case, all your rental assets were sold).

Understand that if more than the property itself is listed in your assets list, then you need to allocate your sales price across all of your assets.  You will only allocate the structure sales price; you will NOT allocate the land sales price, since the land is not a depreciable asset.  Then if you sold this rental at a gain, you must show a gain on all assets, even if that gain is $1. Likewise, if you sold at a loss then you must show a loss on all assets, even if that loss is $1

Basically, when working through an asset you select the option for "I stopped using this asset in 2017" and go from there. Note that you MUST do this for EACH AND EVERY asset listed.

When you finish working through everything listed in the assets section, if you ever at any time you owned this rental you claimed vehicle expenses, then you must also work through the vehicle section and show the disposition of the vehicle. Most likely, your vehicle disposition will be "removed for personal use", as I seriously doubt you sold your vehicle as a part of this rental sale.

[Carl]

I have been using TT for years. We have a second home, that gets rental income during summer months. We have had this property for 10+ years. For each of the years, total expenses + depreciation exceeds the income on the property.

It is "extremely" rare for residential rental real estate to ever show a "taxable" profit on paper at tax time - especially if there's a mortgage on the property. Usually, the mortgage interest, property taxes, insurance and the depreciation you are required to take by law, will exceed the rental income received. Add to that other rental expenses and you're practically guaranteed that deductions will exceed the rental income each and every year.

We notice that TT has been carry forwarding Depreciations (that we could not take). As of now we have accumulated $100k+ carryforward depreciation (shows up on line #18 of TT's Schedule E worksheet) accumulated. I am guessing TT chose to Carry Forward depreciation instead of taking full depreciation and Carry Forward the net losses of expenses. 

TurboTax doesn't "choose" that. It's what's required by law. Once your rental deductions and expenses reduce the taxable rental income to zero, all remaining losses are required to be carried forward. So you'll note that your carry forward losses just get bigger with each passing year.

Now we are selling the property. So a few questions -

1) why did TT chose to carry forward depreciation instead of carry forward losses (or are they same, or difference as far as IRS is concerned)?

All losses get carried forward. With depreciation though, when you sell the property you are required by law to recapture that depreciation in the year you sell the program. That recaptured depreciation will be taxed anywhere from 0% to a maximum of 25%.

2. In filling the 4797 while selling, will the carry over depreciation appear as PAL carry over?,

In the year you sell, all depreciation is recaptured and taxed, period. One way to look at it is to say that your cost basis in the property is reduced by the amount of depreciation, thus increasing your taxable gain on the sale. (or reducing your loss if you sell at a loss.)

So after depreciation reduces your cost basis, your taxable gain is figured by subtracting that adjusted cost basis from your sales price.  Next, any carry forward losses are subtracted from that gain, thus reducing the amount that is taxable. Finally, if the subtracted losses reduce your taxable gain to zero, then (and only then) are any remaining losses deducted from other "ordinary" income.

3. Assuming yes to #2, how/where does IRS know that we have carry over depreciation accumulated?

Because you've been reporting your depreciation and carry over to the IRS on IRS Form 4563 as well as the form 8582 which is filed with the SCH E each year.

Basically, assuming this property was still classified as a rental at the time of the sale, if you just work the sale through the SCH E section of the program, then the program will take care of depreciation recapture and carryover's "for you". Just follow the guidance below.

Reporting the Sale of Rental Property

If you qualify for the "lived in 2 of last 5 years" capital gains exclusion, then when prompted you WILL indicate that this sale DOES INCLUDE the sale of your main home. For AD MIL personnel who don't qualify because of PCS orders, select this option anyway, because you "MIGHT" qualify for at last a partial exclusion.

Start working through Rental & Royalty Income (SCH E) "AS IF" you did not sell the property. One of the screens near the start will ahve a selection on it for "I sold or otherwise disposed of this property in  2018". Select it. After you select the "I sold or otherwise disposed of this property in 2018" you continue working it through "as if" you still own it. When you come to the summary screen you will enter all of your rental income and expenses, even it it's zero. Then you MUST work through the "Sale of Assets/Depreciation" section. You must work through each individual asset one at a time to report its disposition (in your case, all your rental assets were sold).

Understand that if more than the property itself is listed in your assets list, then you need to allocate your sales price across all of your assets.  You will only allocate the structure sales price; you will NOT allocate the land sales price, since the land is not a depreciable asset.  Then if you sold this rental at a gain, you must show a gain on all assets, even if that gain is $1. Likewise, if you sold at a loss then you must show a loss on all assets, even if that loss is $1

Basically, when working through an asset you select the option for "I stopped using this asset in 2017" and go from there. Note that you MUST do this for EACH AND EVERY asset listed.

When you finish working through everything listed in the assets section, if you ever at any time you owned this rental you claimed vehicle expenses, then you must also work through the vehicle section and show the disposition of the vehicle. Most likely, your vehicle disposition will be "removed for personal use", as I seriously doubt you sold your vehicle as a part of this rental sale.

[EnergySaver29]

Thank you @Carl for a very detailed answer. Than you @Critter. Like Carl said, yes, TT will probably take care of the complexity thru easy-step process.

I was trying to understand the details for my satisfaction. Let me take an example and advise if I got it right. 

Example: Assume the rental property was bought for 500,000 in 2010, and sold in 2019 for 450,000. Assume sale exp zero. Capital improvements done over the years 50,000. Depreciations on the building/content "allowed" were say 150,000 for the years. Depreciation carryover cumulative balance  2019 = 100,000. 

Cost basis = 500,000 + 50,000 = 550,000

Gain = 450,000 - (Basis - Depreciation-allowed) = 450,000 - (550,000 - 150,000) = 50,000

1031 non-recaptured losses/carryovers = 100,000 

Net gain (loss) = 50,000 - 100,000 = (50,000) loss that can be taken against ordinary income

[Carl]

Sorry, but with your numbers you don't have a loss.

Cost basis = 500,000 + 50,000 = 550,000

Adjusted cost basis in year of sale is $550.000 minus $100,000 of depreciation is $450,000

Sale price - $450,000

Gain = 0

With your numbers, taxation of the recaptured depreciation does not occur and there are no more losses to take against any other income.

[Carl]

Cost basis = 500,000 + 50,000 = 550,000

Adjusted cost basis in year of sale is $550.000 minus $100,000 of depreciation is $450,000

Sale price - $450,000

Gain = 0

With your numbers, taxation of the recaptured depreciation does not occur and there are no more losses to take against any other income.

[evelynacaldwell]

The response from Critter (https://ttlc.intuit.com/community/user/viewprofilepage/user-id/17697) was really helpful, but I do you have a reference for adding the disallowed depreciation carryforward to the basis of the property upon sale? I just need that for my documentation.

[Carl]

Depreciation is not added to your cost basis when you sell. It's *subtracted* from your cost basis when you sell.

So regardless of your carry over expenses, all depreciation taken *is* accounted for in the year you sell.

So if you have a cost basis of $550,000 with $100,000 of depreciation in the year you sell, your "adjusted" cost basis is $450,000. If you sell for $450,000 you don't have a gain or a loss. Any other carry over expenses are then deducted from "other" ordinary income at a maximum of $3000 a year until they are all used up.

Now don't confuse that $3K/year limit with the $25K allowed each year (including the year you sell) ***IF*** you were an active participant in the rental activity.

[M-MTax]

there's no $3k/year limit when you sell something like a rental property at a loss....it's an ordinary loss not a capital loss and that can reduce all other types of income without limitation.

[AmeliesUncle]

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@evelynacaldwell wrote:

The response from Critter (https://ttlc.intuit.com/community/user/viewprofilepage/user-id/17697) was really helpful, but I do you have a reference for adding the disallowed depreciation carryforward to the basis of the property upon sale? I just need that for my documentation.

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Technically, it isn't "added" to the Basis.  But the unallowed depreciation just is NOT "subtracted" from the Basis (depreciation that is used lowers the Basis).  That is because was not "allowed" and it was not "allowable".

As a side note, there is a potential argument that the disallowed losses could be fully used in the year of the sale, just like Passive Loss Carryovers.  It is an unlitigated "gray area", but I think most tax professionals lean towards that is NOT allowed.

[Critter-3]

Passive unallowed losses on the Sch E becomes a deduction on the Sch E in the year of sale ... it doesn't show up on the form 4797 or the Sch D ... that is where the depreciation recapture happens.   So the amounts technically balance themselves off in the year of sale so you don't "pay taxes twice".   When you are done review the amounts carefully to see how they work in harmony.