Primary residence converted to rental property depreciation not claimed

[Freefall1115]

Good afternoon,

My wife and myself purchased a primary residence in 2015, we relocated and began renting out the property since January of 2017.  Currently I have a tenant vacating and was looking into selling the property.  Within that time of converting our primary to a rental we purchased a second rental in 2022 as well.

I have filed my own taxes and knew that my second rental auto populated the depreciation every tax filing and even with my first property entering in the data it would show 0 depreciation.  I never thought much of this as most of the years the maintenance and rental income would not show a large profit.  

The purchase of this property was around $126,500 and if I were to sell it would be around $265k.  With not realizing the depreciation was not offsetting and being factored in for taxes how worried should I be?  I just began looking into the depreciation recapture and have seen that up to 25% of the possible depreciation that I did not file would be recaptured at sale.  

My question to this also is if I was not deducting or calculating the depreciation on my own for this one property yearly what could the amount be that could be recaptured?  Our other property is around the same value and has loosely $10k depreciated a year from the records I have.  

I almost want to keep renting it so I can sort this out and get the depreciation sorted out.

-If I didn't deduct, essentially paid more in taxes yearly due to missing this deduction and not reducing my taxable income would that not be as big of an issue from this time period?  Get more tax back yearly from returns and then pay more at the end?

I feel like I screwed myself for a simple mistake that I saw during tax season every year but just thought with all my info entered that Turbo didn't question the "0" in depreciation.

Last question is refinancing doesn't stop the depreciation to a certain level or change the amount yearly you can deduct?  

Any solutions or ideas if I do sell this house prior to the end of the year?

[Opus 17]

You must pay recapture on the depreciation that you claimed or could have claimed, even if you didn't claim it.  

When you place a property in service as a rental, you are asked the basis for depreciation.  That would be your adjusted cost basis, or the present fair market value (whichever is lower), less the value of the land because land doesn't depreciate.  It sounds like you did not enter a basis, although someone needs to check your tax returns to be sure what the problem is.

You recapture all the depreciation, the tax rate is ordinary income, capped at 25%.  So the rate could be 10%, 12%, 22%, or 25%, depending on your other income, deductions and filing status.  The calculation works something like this:

Original cost: 100,000

Improvements added to basis 20,000

Depreciation 30,000

Adjusted cost basis 90,000

Selling price 200,000

Capital gain (proceeds minus basis) 110,000

Gain due to recapture 30,000 -- taxed as ordinary income

Remaining gain 80,000 taxed as long term capital gains (15% or 20% depending on other income)

If you failed to take depreciation, you must still pay tax on the recaptured depreciation you should have taken.  To get a tax deduction (tax benefit) for the depreciation you should have been taking, you need to file form 3115.  This is complicated and you will almost certainly need the help of a tax professional.  Take all your old tax returns and other documents to a professional and ask for their help. 

[Freefall1115]

based off of your example with 110k in capital gains between 4.5-6k of tax recoupment missed out would be nominally expected? 

Thank you,

with the added taxes paid for the years missed with the tax return based off of this it doesn’t seem like an exponential number.

[Opus 17]

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@Freefall1115 wrote:

based off of your example with 110k in capital gains between 4.5-6k of tax recoupment missed out would be nominally expected? 

Thank you,

with the added taxes paid for the years missed with the tax return based off of this it doesn’t seem like an exponential number.

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I don't understand your comment or question.  Could you rephrase?

Rental property is depreciated over 27.5 years.  If you sell the property now, we are talking about 8 years of depreciation.  So roughly 29% of the original cost basis minus land.  For example, if the cost was $100,000 and the land was worth $10,000, then you should have depreciated starting at $90,000 and you would have taken $26,000 of depreciation deductions.  That would have saved you (over those 8 years) somewhere around $4000-$6000 of federal income tax, plus some amount of state income tax.  If you file form 3115, you would get some of that refunded to you now, although I don't know how much. That would offset some of the tax you must pay on the sale.  Whether the tax savings from filing form 3115 would offset the cost of the professional help is something you will have to evaluate.  

Even if you don't correct your past depreciation, you will have to put some effort into calculating what the depreciation would have been at the time, so you can determine your correct adjusted basis and the correct allocation of your gain between long term capital gains and recapture.

[NCperson]

@Freefall1115 it would be best to pay a tax preparer in the year you sell the property so they can do this correctly and fix the problem of the depreciation not taken in years past.  You want to get this right and paying someone to do it for this one year would be worth it.