Why is TurboTax classifying depreciation recapture as long term capital gain?

[NDiMas]

Hello,

I sold a rental property in 2022 for a gain. I can't figure out why TurboTax is classifying a portion of the depreciation recapture as long term capital gain. Here is a detailed description of what is happening.

When I put the property into service as a rental, I listed the values of the original structure and land. Then I listed out all the individual improvements I had made and the amounts I had paid for them. Over the course of a couple years, I took depreciation on the original structure and the improvements. Now when I'm selling, I have gone into the program and listed the sale price of each individual improvement to be equal to the undepreciated price I originally paid for the improvement. This ensures that the program is recapturing all the depreciation I took on each individual improvement as ordinary income. 

The issue I'm having is the depreciation I took on the original structure, which is classified as "residential rental" under type of asset (I believe this was the default for the original structure and land when I allocated values to those items upon putting the property into service as a rental). When I look at form 4797, it is listing the depreciation on the original structure as a long term capital gain, which it then sends over to Schedule D, Line 11 for purposes of calculating capital gains tax. 

My understanding is that all depreciation recapture is supposed to be taxed as ordinary income. Is the program correct in instead classifying the depreciation on the original structure as a long term capital gain? Or have I accidentally put something in wrong?

Thanks!

[NDiMas]

Answering my own question here.  It is because the depreciation on the original structure is considered "unrecaptured Section 1250 Gain."  This article explains it well:

https://www.investopedia.com/terms/u/unrecaptured-1250-gain.asp#:~:text=An%20unrecaptured%20section%....

I was unaware that the depreciation on the original house structure is considered a capital gain and can be offset by other capital losses. According to the article, that is the case.

It's interesting to me that the improvements I made over time are considered personal property, are classified as Section 1245 property, and therefore the depreciation is taxed as ordinary income rates and cannot be offset by capital losses. But the original house structure is considered residential real estate, is classified as Section 1250 property, and therefore the depreciation is treated as a capital gain that can be offset by capital loses and is subject to its own separate maximum taxation rate.  I don't understand why it should work this way, but it does appear to be the case, based on what I have read.

[Mike9241]

you may have misclassified the improvements. if they become a permanent part of the struct they are real property 

[Carl]

Not only can the MACRS asset classification cause what you see, but so can reporting losses on some assets and gains on others.

If you sell at a gain, it's important to show a gain on all assets. Doesn't matter if the gain is $1 on some assets, and $100,000 on other assets. A gain is a gain, is a gain, is a....

When you show a gain on some assets and a loss on others, the depreciation is not correctly recaptured and taxed as ordinary income on those assets you show a loss on. Instead, that recaptured depreciation is included in the gain and taxed at the capital gains tax rate.

[NDiMas]

Thanks, Mike.  That does make sense.  If I did misclassify some of the improvements, is it acceptable to reclassify them now at the time of sale, or will that mess up the depreciation calculations?

[RobertB4444]

If you change the classification now it may change the depreciation allowed because of the change in the time you depreciate the assets.  But as long as you make certain that the prior years' depreciation is correct changing the classification should only change the allowable depreciation for this year and since you're disposing of the asset and recapturing all of the depreciation that you took it shouldn't make any difference.

@NDiMas 

[Carl]

changing the classification should only change the allowable depreciation for this year and since you're disposing of the asset and recapturing all of the depreciation that you took it shouldn't make any difference.

Unfortunately, due to programming limitations the program just flat out will not work that way.  If you change from say, 5 year depreciation to 27.5 year depreciation, the program will incorrectly assume you took the correct depreciation in prior years, thus making the current year's depreciation follow suit. So you will be recapturing much less depreciation than was actually taken.

Since you sold the property in 2022 it's best to leave well enough alone and report the sale "as is" so you will correctly recapture the depreciation that was actually taken, since it is the higher amount.

Remember, you have to recapture the "higher" of depreciation taken, or the depreciation you should have taken.

[NDiMas]

To be honest, I have found TurboTax’s whole approach to investment properties inadequate.  From placing the property into service until final sale, the questionnaires simply aren’t designed to ensure that someone with little to no prior experience enters the correct information.  I wouldn’t recommend it to a first timer.  It took quite a bit of research and working around the program’s limitations to make sure it came out correctly.  This isn’t really acceptable for a program marketed towards do-it-yourself homeowners.  It seems that, with minimal additional investment, they could design better questionnaires that would guide people to better outcomes.  I’m not sure why they don’t fix the shortcomings.

[Carl]

I’m not sure why they don’t fix the shortcomings.

It is just not possible to make 100% of the people 100% satisfied. This is true in any business model. As the program is now, it's already bloated beyond what I consider acceptable. But it is what it is. With congress's inability to "leave things alone" with constantly changing tax laws every year, I find it amazing that any tax prep software company would even try to keep up.

But there's more politics behind it than most people know. Won't get into it here, as that's not within the scope of this forum.

[NDiMas]

I don’t disagree with you, but the issues I’m flagging with the program don’t really have anything to do with recent changes to the tax code.  These are the basics of placing a rental property into service, allocating values to land, structure, and improvements, and then allocating the price of sale to all those sane things to calculate depreciation recapture at the time of sale.  The software simply does not ask the right questions to ensure those values are put in properly.  You have to work around the problems with the questionnaire to make sure everything is put in correctly.  This is just poor design and programming.  TurboTax could do better.