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BunnyGo
Level 3

Future Tax Implications of Depreciating Rental

Hello,

 

While my primary residence sits on the market to sell, we rented it out to a tenant. So far so good.

 

Since we lived in it for at least 2 of the last 5 years, when it sells we'll be able to get the $500,000 property exclusion as per this IRS advisory page:

 

https://www.irs.gov/faqs/capital-gains-losses-and-sale-of-home/property-basis-sale-of-home-etc/prope...

 

But, we're also depreciating the value of the home while it's a rental unit. And I cannot figure out whether or not and how this may cause future tax implications when we sell. Can anyone provide references or clarify the issue for me? Thank you.

 

P.S. If the answer is: "You'll just have a lower cost basis when you sell the house" that makes sense to me. If it's something else, then I'll need more help.

1 Best answer

Accepted Solutions
BarbL
Employee Tax Expert

Future Tax Implications of Depreciating Rental

Unfortunately, it is "something else". 

 

The capital gains exclusion does not apply to any gains attributable to depreciation (since May 6, 1997).  So, while your tax basis is technically reduced by the amount of the depreciation, the depreciation is handled differently at the time of sale.

 

During the period it is a rental, you are required to claim depreciation and will receive the benefit of a depreciation deduction which offsets ordinary income tax rates.  When you sell, those depreciation deductions are 'recaptured', but not at the more favorable capital gains rates.  

 

So, assume your gain on the sale is $200,000 and you have claimed $25,000 in depreciation during the rental period.  At tax time, you will have $0 in capital gains (assuming you qualify for the exclusion), but $25,000 in depreciation recapture taxed at a flat rate.  

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3 Replies
BarbL
Employee Tax Expert

Future Tax Implications of Depreciating Rental

Unfortunately, it is "something else". 

 

The capital gains exclusion does not apply to any gains attributable to depreciation (since May 6, 1997).  So, while your tax basis is technically reduced by the amount of the depreciation, the depreciation is handled differently at the time of sale.

 

During the period it is a rental, you are required to claim depreciation and will receive the benefit of a depreciation deduction which offsets ordinary income tax rates.  When you sell, those depreciation deductions are 'recaptured', but not at the more favorable capital gains rates.  

 

So, assume your gain on the sale is $200,000 and you have claimed $25,000 in depreciation during the rental period.  At tax time, you will have $0 in capital gains (assuming you qualify for the exclusion), but $25,000 in depreciation recapture taxed at a flat rate.  

BunnyGo
Level 3

Future Tax Implications of Depreciating Rental

Thank you very much!

 

One follow up question, do you have a reference for this? I searched for a while and couldn't find one.

BarbL
Employee Tax Expert

Future Tax Implications of Depreciating Rental

Yes, begin with this IRS FAQ, then select the "Publication 523, Selling Your Home" link at the bottom of the FAQ answer. 

 

 https://www.irs.gov/faqs/capital-gains-losses-and-sale-of-home/property-basis-sale-of-home-etc/prope...

 

 

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