Selling Rental of 15 years and impact depreciation has on capital gains.

[LeathalPeach23]

I am considering selling my rental of 15 years but don't quite understand what the impact depreciation will have on my taxes. With that said I learned that you are required to depreciate expenses if they exceed a certain dollar amount, yet was under the impression depreciation can come back to haunt you if you sell the property. I am naïve on this subject as my intention was to keep this property indefinitely...but times change. Thanks for any insight.

[DawnC]

When you sell the property, you have to recapture the depreciation that you have taken (or should have taken) over the years.  You have to recapture it whether or not you take the deduction.  You are required to recapture the allowable depreciation, meaning the depreciation you could have claimed, not the amount you actually claimed a deduction for.  

Rental expenses are not depreciated.  You only depreciate the property itself and any capital improvements.  Capital improvements that add to the value of your rental property, prolong its life, or adapt it to new uses must be depreciated over a period of time rather than deducted as a current-year expense.  

What is rental depreciation and how does it differ from an expense?

Depreciation recapture can cause a significant tax impact if you sell a residential rental property. Part of the gain is taxed as a capital gain and might qualify for the maximum 20-percent rate on long-term gains, but the part that is related to depreciation is taxed at the higher tax rate of 25%.

Now here's some good news. Any passive activity losses that were not deductible in previous years now become fully deductible when a rental property is sold. This can help offset the tax bite of the depreciation recapture tax.

Tax Deductions for Rental Property Depreciation

[LeathalPeach23]

If I am understanding you correctly, say it costs $100,000 to purchase the home. Over 10 years you depreciate a total of $50,000. You sell the house at $150,000 (CMV). If I had net equity of $100,000, $50,000 would be taxed at 20% for capital gains and then the $50,000 I depreciated would be taxed at 25% giving me a net $55,000 in my pocket? In other words, my total capital gains tax would be $45,000.

I am assuming Turbo Tax would calculate this all out once the property is sold and reported on taxes? Thank you.

[Critter]

Yes ... and the program will calculate everything just follow the screen instructions carefully. 

[Carl]

As I'm sure you're aware, you are required by law to depreciate rental property. Many incorrectly believe that depreciation is a permanent deduction from their taxable income. it is not.

Depreciation is a reduction of your cost basis. You are required to depreciate any property that is used to produce income. However, land is not depreciable. Only the value of the structure is depreciated.

So if you paid $100,000 for a rental property 10 years ago, that first year renting it out you would have been required to provide a value for the land that rental property sits on, and a separate value for the structure itself. So for this scenario lets say the land was valued at $30K and the structure was valued at $70K. That means you would be required to depreciation the $70K value of the structure over 27.5 years. Therefore over ten years you would have taken approximately $2,541 each year for a total of $25,410 over 10 years.

So after 10 years you sell the property for $90,000. You would think that since you purhcased it for $100,000 that would be you sold at a loss. But not so fast. That $25,410 of depreciation is subtracted from your cost basis of $70K on the structure. So you subtract the $25,410 of depreciation you took from your original $100K you originally paid for it, and you have an adjusted cost basis of $74.590.

So if you sold the property for $90K that means you have a taxable gain of $15,410

Now the above is an extremely simplistic scenaro. In reality, you may have property improvements that will increase the cost basis (which are depreciated also) as well as deductible things related to sales expenses and the such.  For example, since rental property always operates at a loss on paper at tax time, in the year you sell you first deduct all your carry over losses from your taxable gain. So that reduces your taxable amount even more.

[LeathalPeach23]

Appreciate this Carl. I will apply this to the actual numbers and see what I come up with. Thank you.

[Carl]

My scenario is extremely basic and leaves a lot out.  All kinds of other things will affect your taxable gain if any, on the sale. For example, there's your closing costs and carry over losses that will reduce taxable gain.

[LeathalPeach23]

Thanks Carl. I actually ran the real numbers and a question came up at the end. I am assuming if you still had a mortgage on the property that needed to be paid off would be part of the adjusted cost basis? In other words, I have a potential sales price of $360k but still owe $147k on the property. Or does any mortgage balance still owed on the property have no affect on the adjusted cost basis? Thanks for all your insights. 

[DoninGA]

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@LeathalPeach23 wrote:

Thanks Carl. I actually ran the real numbers and a question came up at the end. I am assuming if you still had a mortgage on the property that needed to be paid off would be part of the adjusted cost basis? In other words, I have a potential sales price of $360k but still owe $147k on the property. Or does any mortgage balance still owed on the property have no affect on the adjusted cost basis? Thanks for all your insights. 

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The mortgage balance is not relevant to calculating the adjusted basis of the property.   The Adjusted Basis of the property is only the Purchase Price plus the cost of improvements to the property prior to the sale.

The mortgage balance or payoff is also not used in the calculation for the gain or loss on the sale of the property.