What capital gains to expect from depreciating primary residence

[Nikkinoodle1991]

I co-own a duplex with my brother, which we were told to fully depreciate beginning the first year we owned it. We had one tenant but we both lived there for three years (2018-2021). I moved out in 2021 and brought tenants into my part of the duplex, but my brother still lives there and has considered the house his primary residence since 2018 (though he's always had at least one tenant). I understand that I will need to pay capital gain when we choose to sell, but will he? If so, are the capital gains inflicted because I no longer reside in the home, because we've been depreciating it 100% since 2018, or a combination of both?

[tagteam]

If your brother owned the duplex and lived in one unit as his primary residence for the last 2 out of 5 years leading up to the sale, he can exclude some (or all) of the capital gain on that unit (only). 

Since you will not have used that unit as your primary residence for the last 2 out of 5 years leading up to the sale (it's already been circa 3 years since you moved out), you will not be able to take advantage of the home sale exclusion.

See https://www.irs.gov/taxtopics/tc701

There is really no way to avoid any depreciation recapture and, hopefully, you and your brother have been treating the two sides as separate living units and taking depreciation deductions only on the unit that was being held for rental use.

[Nikkinoodle1991]

Thank you for the quick response! I just want to make sure the fact that we've been depreciating the entire doesn't change that. I understand we'll have to deal with depreciation recapture, but can you confirm that even though we've been depreciating 100%, he won't have to pay capital gain because that's his primary residence?

[tagteam]

If either one of you have been living in one of the units, then you should not have been taking depreciation deductions on the entire structure (100% of it). 

Depreciation deductions taken (accumulated over the years) are recaptured upon disposition of the property regardless of whether any home sale exclusion is available.

[Opus 17]

I'm not clear on the facts.

From 2018 to 2021, no depreciation should have been claimed because it was only your personal residence.  From 2021 through today, your brother could depreciate a percentage of the duplex equal to the percentage being rented out (on a square foot basis), but 100% depreciation was never allowed as long as he was using one unit as his personal home.  You and your brother need to see an accountant to help you file a form 3115 to correct the erroneous depreciation.  

(Or, if you and your brother lived together in unit #1 and unit #2 was always rented, then you could have depreciated only unit #2, on a percentage basis.  You still need an accountant to help you file form 3115 to correct the error.  As I said, the facts are not entirely clear.)

Also, you never depreciate 100% because land doesn't depreciate.  You have to subtract the value of the land.  Suppose that whenever it became a rental, the cost basis (what you paid in 2018 plus any permanent improvements) was $200,000, and the land was valued at $40,000.  Your basis for depreciation would be $160,000, and if the units were equal sized, your brother could list the rented half the property ($80,000) for depreciation, but only when it was actually rented or available for rent.

As far as taxes when the home is sold are concerned, you will always pay recapture first.  It works like this:

Suppose you sell in 2025 for $400,000.  Your original cost was $200,000, and the correct depreciation ($80,000 starting value over 27.5 years is $2909 per year, 4 years would be $11,636.  (If unit #2 was rented since 2018, then you can recalculate my example using 7 years of depreciation, but the basic calculation is the same.)

Your basis is reduced by depreciation, so your basis is now $188,363 and your gain is $211,636.  If you own the property equally, then each sibling's basis is $94,181 and each sibling's gain is $105,818.  

The first $5,818 of gain is taxable to each brother as depreciation recapture.  For you, the remaining $100,000 of gain is fully taxable because the home was not your personal residence for 2 of the previous 5 years.  As long as your brother is still living in one unit as a personal residence, his $100,000 of gain is covered by the personal exclusion. 

[Nikkinoodle1991]

I recognize that we shouldn't have been depreciating the home 100% but we did. My question is does that affect capital gains? 

[Opus 17]

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@Nikkinoodle1991 wrote:

I recognize that we shouldn't have been depreciating the home 100% but we did. My question is does that affect capital gains? 

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Any depreciation reduces your cost basis, which means it increases your gains when the gain is calculated (selling price minus basis).

Then, the portion of the gain that is attributed to depreciation is taxed using the recapture rules -- ordinary income tax rates, with a cap of 25%.  The remainder of the gain is taxed according to the normal rules for capital gains, which includes lower rates for long term capital gains (15% or 20%) as well as the exclusion for one's main home, if you qualify.  

[tagteam]

@Nikkinoodle1991 

You really do need to engage a tax professional to rectify your situation. 

See https://taxexperts.naea.org/expertdirectory

More likely than not, a Form 3115 will have to be filed to correct the fact that you adopted an impermissible method of accounting with respect to depreciation (which is not something you want to handle yourself).

See https://www.irs.gov/instructions/i3115#en_US_202212_publink100035827