Depreciation recaptured on primary residence

[smitchells]

We sold our primary residence in 2020.  We lived in the house over 2 years out of the last 5 prior to the sale and have owned it for 20+ years.  We should qualify for the $500,000 exemption for sale of primary residence.

In 2015 we rented the house for a few years while we travelled, and took depreciation deductions.  The renters moved out 8/1/18 and we moved back in 8/1/18.  We lived in the house until the end of November 2020 when we sold the house.

I understand we need to reduce the basis of the house by depreciation taken, which increases our gain.  However, the gain is still way under the $500,000 exclusion when you sell your primary residence.  Since I reduced the basis by the amount of depreciation, that is in effect recapturing the depreciation.  Why does TurboTax add that same depreciation into our ordinary income.  Taxing it twice in a way.  Turbo Tax is reporting the depreciation amount on Schedule D along with our other Capital Gains, but then that amount is pulled out during the tax calculation and taxed as regular income.  Why?  I already recaptured the depreciation by subtracting it from our basis, thereby increasing profit.  The profit is still below the $500,000 exclusion amount.  

If the depreciation is recaptured twice, both by reducing basis and taxed as ordinary income, does CA Franchise Tax Board (FTB) also tax the same amount?  I asked in an FTB Chat whether they recaptured depreciation if the gain is under the $500,000 exclusion.  Their response was "We do not include that as taxable income because it is still within the excludable amount.   You can make an adjustment on Schedule CA".  TurboTax transfers the depreciation amount as taxable to the California return.  So, which is correct?

CA conforms to IRS Sale of Residence rules.  Doesn't that mean it is also not taxed on the Federal return? 

Thank you,

Sue

[AmeliesUncle]

---

@smitchells wrote:

In 2015 we rented the house for a few years while we travelled, and took depreciation deductions.  The renters moved out 8/1/18 and we moved back in 8/1/18.  We lived in the house until the end of November 2020 when we sold the house.

Why does TurboTax add that same depreciation into our ordinary income.  Taxing it twice in a way.  Turbo Tax is reporting the depreciation amount on Schedule D along with our other Capital Gains, but then that amount is pulled out during the tax calculation and taxed as regular income. 

---

How much is your total gain?  The fact it was rented out and then you moved back into it means your gain is prorated because you have "Nonqualified Use".  If your total gain is less than $500,000, it would NOT all be able to be excluded and you will owe some tax (in addition to the depreciation).

It is not being taxed twice (unless you entered something incorrectly).  As you said, it is being pulled OUT of your capital gains and taxed at your regular tax rate (up to 25%).  So if your tax return shows $30,000 of capital gains, of which $20,000 are from depreciation, it would tax $10,000 at the capital gain rates and $20,000 at your regular tax rate (up to 25%).

[Mike9241]

put another way,  any gain (based on the reduced basis) is taxable up to the lesser of the gain or the depreciation taken.

[smitchells]

From what I read "nonqualified use" only applies if our original use on the home was a rental,  and later we converted to a personal residence.  To prevent people from moving into their rental properties for two years just to get the $500,000 exclusion.  We lived in the home from date of purchase for 20 years before renting it for three.

If you decrease basis by depreciation,  increasing your gain (which you are taxed on if over $500,000), plus you recapture that same amount and pay an additional 25% tax on that as ordinary income (even if gain is way under the $500,000),  you are basically paying tax on the same amount twice.

It feels like double taxation to me.

Anyways, is this accurate?  Is depreciation both subtracted from basis  AND added to ordinary income?  I was hoping I was doing it wrong!

Does California conform and tax it the same? 

Thanks

[AmeliesUncle]

---

@smitchells wrote:

From what I read "nonqualified use" only applies if our original use on the home was a rental,  and later we converted to a personal residence.  

If you decrease basis by depreciation,  increasing your gain (which you are taxed on if over $500,000), plus you recapture that same amount and pay an additional 25% tax on that as ordinary income (even if gain is way under the $500,000),  you are basically paying tax on the same amount twice.

It feels like double taxation to me.

Anyways, is this accurate?  Is depreciation both subtracted from basis  AND added to ordinary income?  I was hoping I was doing it wrong!

Does California conform and tax it the same? 

Thanks

---

Nonqualified Use applies if it was a rental (or anything other than your Principal Residence) before it was your Principal Residence.  It does not matter what the "original use" was.  You said you moved back into the home in 2018 (after it was rented), and that triggers it to be Nonqualified Use.

As I said before, it is not taxed twice.  Maybe an example will help:

Let's say you bought the home for $300,000, took $100,000 of depreciation, and sold it for $500,000.

Your total gain is $300,000 (Sales Price of $500,000 minus your Adjusted Basis of $200,000).  OF that $300,000 gain, $100,000 is Unrecaptured 1250 Gain (tax due to the depreciation), and the other $200,000 is taxed as long-term capital gain.

So even if you had $0 depreciation, you would pay tax on the $200,000.  But because you had $100,000 of depreciation, you pay tax on that $100,000 when it is sold.  It is only taxed once.

[Funda53]

Do I need to recapture depreciation on state return (California)?  Home was primary residence excluded from gain and now we are WA residents but home was in California.  I understand we have to pay federal income tax on the recaptured depreciation but if we are no longer CA residents, do we need to pay there too?

[tblasz]

For your example (the 500,000 sale), she wouldn't have to pay back the capital gains on the 300,000 because she lived in it the last 2 years, right? 

Regardless of how long you lived in the house right before it was sold, you will always have to pay the depreciation recapture back correct?

I understand for high earners the depreciation recapture rate would be 25% but what if the year you sold it you didn't have any income, would the depreciation recapture % be 0%?

[Mike9241]

assuming the simplest scenario the 1250 recapture is taxed at the lower of your marginal tax rates or @25%. so if you are in the zero% tax bracket the 1250 gets taxed at zero.   

[tblasz]

Sorry, I want to make sure I really understand this. In the previous simplified scenario:

"Let's say you bought the home for $300,000, took $100,000 of depreciation, and sold it for $500,000.

Your total gain is $300,000 (Sales Price of $500,000 minus your Adjusted Basis of $200,000).  OF that $300,000 gain, $100,000 is Unrecaptured 1250 Gain (tax due to the depreciation), and the other $200,000 is taxed as long-term capital gain."

If I rented the property previously and then lived in it the last 2 year before selling, I wouldn't have to pay the capital gains on the $200,000.  If I had $0 income the year I sold the house, I would have to pay 0% of the $100,000 depreciation too? I know that's unlikely so lets say it was a retired person and they only made $24,000 a year from social security, the tax that you would have to pay back on the depreciation would be whatever the tax bracket is for $24,000/year (12%)?

[AmeliesUncle]

---

@tblasz wrote:

If I rented the property previously and then lived in it the last 2 year before selling, I wouldn't have to pay the capital gains on the $200,000. 

If I had $0 income the year I sold the house, I would have to pay 0% of the $100,000 depreciation too?

---

No and no.

If you used the home for something else before it became your Principal Residence, there are different rules involved and you have "Nonqualified Use".   That essentially means that the $200,000 is prorated based on the time it was your Principal Residence and your entire ownership period.  For example, if you owned the home for a total of exactly 10 years and you first rented it out for exactly 7 years then it was your Principal Residences for exactly 3 years, you could only exclude 3/10th of it (the actual calculation uses days, not years).  So $60,000 would be tax-free, but the other $140,000 would be taxable.

If we temporarily put the Nonqualified Use rules aside, you asked about the tax rate if you had $0 of income with the $100,000 of gain due to depreciation.  But you would not have $0 of income - you would have $100,000 of income.  You need to INCLUDE the amount of the taxable gain for determining how much is taxable.