Depreciation Recapture - Trying to Understand Logic

[Anonymous]

Hello Community - I am trying to get the concept of depreciation recapture to sink in my brain as it feels that one overpays what he/she needs to pay in taxes. My question is, why does accumulated depreciation reduce the cost basis at the time of house sale? As the example below:

Cost basis: $100k

Accum. Depreciation: $30k

Adj Cost Basis: $70k

Sale Price: $150k

LT gain: $80k - TO BE TAXED AT LT GAIN TAX RATES

PLUS

Accum Depreciation of $30k - TO BE TAXED AT UP TO 25% TAX RATE 

It seems as if it is essentially a double taxation. What would make sense is to keep cost basis at $100k and get LT gain of $50k (pay tax on this LT gain) and pay tax "back" on $30k (accum depreciation)? Essentially:

LT gain: $50k - Pay tax on at LT gain tax rates

Accum Dep: $30k - Pay tax on at up to 25% tax rate

Essentially I am seeing extra $30k in LT gains because of depreciation recapucture but why?

[DMarkM1]

You're example of what makes sense is correct.  The unrecaptured 1250 gain is straight line accumulated depreciation (any accumulated depreciation that wasn't straight line is recaptured 1250 gain taxed at ordinary rates).  In your case $30K is taxed at 25%.  The remaining part of gain $50K is taxed at long term capital gains rates. 

[Mike9241]

technically $50K gets taxed at the capital gain rates

 "Unrecaptured" section 1250 gains — that is, gains on real estate due to straight line depreciation — have their own tax rates of 25% or 15% (depending on the owner´s tax bracket) rather than the 5%-15% capital gains rates. (so you don't pay both the capital gains tax on the 80 and then 1250 recapture tax on the 30) 

one way to see the taxes on the 80 gain is to complete your return without reporting the sale and then report the sale. 

another method is to review the section 1250 recapture worksheet and the capital gain and qualified dividend worksheet.

**********************

would you prefer no depreciation deduction be allowed then you would have a gain of 50

during the years of ownership, you got to deduct and thus reduce your income taxes for the depreciation.

But depreciation lowers tax basis so you now have that depreciation come back as income

so over the years

50 of income for the excess of the sales price over the original cost

-25 the tax deduction you got for depreciation over the years

+25 for depreciation recapture

Thus the net is 50 the same amount as if depreciation was never taken

depreciation never costed you any cash out of pocket strictly a tax and accounting concept.

[Anonymous]

@DMarkM1—please correct me if I am wrong, but do I understand right that the amount of depreciation accumulated does not REALLY affect the total tax to pay at the sale of the rental house? I have passive loss carryforwards (i.e., I am not eligible to deduct those losses, and I keep accumulating them each year until I sell the house), as these passive loss carryforwards will essentially EVEN OUT the depreciation recapture.

[ThomasM125]

It is true that accumulated passive loss carryovers will be deductible in the year you dispose of the property. That loss will be available to offset income from gains recognized on the sale of the property.

[Anonymous]

@ThomasM125 - thank you. Will passive loss carryovers be deducted at ordinary tax rates? Do I understand right that it will also EVEN OUT depreciation recapture, i.e., there is no difference if there has been large or small accumulated depreciation? 

[DaveF1006]

Yes, according to ThomasM125 in his post, "The unused passive losses are used to reduce ordinary income in the current year. Depreciation is recaptured as ordinary income to the extent you have a gain on the sale of the property. So, indirectly the loss carryovers can be used against depreciation recaptured, since they are both ordinary income/loss." 

To answer your question, the passive loss carryovers may not even out ordinary income resulting from a gain of a sale that has depreciation recapture. It may make the ordinary income from the sale smaller however. There is a difference however in the amount of accumulated depreciation being recaptured. If it is a large amount, the taxable gain on the sale of your house could be substantial and the passive loss carryovers may not be sizable enough to negate the gain. 

Passive loss carryovers will reduce the ordinary income amount that is taxed at ordinary tax rates. These carryovers, in themselves are not taxed, but just used to reduce taxable gain. This is what ThomasM125 mentions in his previous post and how indirectly they play a part in reducing your taxable income from the sale of your property.

If your passive loss carryovers exceed the ordinary income from the sale reporting depreciation recapture, then your taxable income will be zero.

@wully691