Tax question on primary residence to rental property
Do you need to take the depreciation when you rent out the property? I think
I’ve read somewhere that for rental properties if you don’t take the
depreciation, you’ll still be hit by depreciation recapture when you sell.
Is this right?
You don’t have to take the depreciation. I believe I read on the IRS’s web site you will
still be hit by depreciation when selling weather you took it or not. I don’t remember
which publication it was 2-3 years ago, contact an accountant about it.
Thanks,
Mike.
ANSWER
Mike,
The IRS assumes you are taking depreciation all along and charges you back for all of the deprecation (whether you took it or not) when you sell the property.
What this means, for those of you new to depreciation, is that the IRS allows and expects that you will take a tax deduction equal to the acquisition cost of a property divided by 27.5 (years). For example, if you buy a house for $100K, each year you get to depreciate $3636.36 of it’s value, which is a “passive loss” tax deduction. These “losses” are a great benefit of owning rental property, because they offset income and thus reduce your taxes each year.
If you hold the property for 27.5 years, you will have depreciated the entire $100K, and thus you can no longer take depreciation (although you can take more if you have made improvements along the way). If you then sell the property for $200K, you profit IS NOT $200K (sale) minus $100K (purchase) = $100K (profit), as some people believe, but IT IS INSTEAD $200K (sale) minus $0K (the depreciated value) = $200K profit, ALL OF WHICH is taxed, at long-term rates. Yes, that’s what I said, after 27.5 years the IRS assumes you took all the depreciation and assumes that whatever you sell the property for is 100% profit, and taxes it all.
Because you are always going to have to pay taxes on the depreciation at sale, I can’t think of any reason not to take the depreciation each year.
Now, of course if your income is over $125K (in which case your deductions are limited) and/or you don’t have sufficient passive income to offset the deduction, you may say “I don’t need, want, and can’t use the deductions this year”. That may be the case, but you pretty much need to take it anyway, and just roll forward (the deductions/”passive losses” ), on your tax return, any so they can be used in future years.
If you do this, then in the example I gave earlier, you take the $3636.36 deduction each year, but because you can’t offset the deductions, you just keep rolling them forward. After 27.5 years, you still sell the property for $200K, but now you can deduct the $100K of “rolled forward” losses from the last 27.5 years, from the $200K profit, thus reducing your profit from $200K back down to $100K.
Of course in the more likely scenario where you start making increasing amounts of income off of your property, that income can be offset by the rolling losses making the income tax free or tax reduced along the way.
Phill
