Author Topic: rental property depreciation recapture in retirement?  (Read 13749 times)

sol

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rental property depreciation recapture in retirement?
« on: June 12, 2014, 06:52:47 PM »
I think I understand rental property depreciation recapture, in which you are effectively taxed upon sale for paper gains incurred by depreciating a property.  Every year our current taxes are reduced by a few thousand dollars because our AGI is adjusted down by the depreciation, and upon sale we're going to pay 25% tax on the cumulative depreciation (in addition to 15% on any actual appreciation).
 
The concerning part is that if we continue to hold the rental property after we retire, our marginal tax rate will be much lower than 25%.  A married couple filing jointly can live quite comfortably on $30k/year while paying zero income tax, if they're utlizing the right deductions.  In this scenario, we're getting an up-front  "tax break" on the rental property depreciation that is effectively worthless to us, and then we'll have to pay a 25% tax rate on the depreciated amount upon sale.
 
Is there some sort of rule that says you only pay rental property depreciation recapture on the actual realized value of the depreciation?  Because if not, holding a rental property and continuing to depreciate it after your income drops below the 25% bracket in early retirement seems like a losing proposition.  I'd be inclined to sell our rental properties as soon after our retirement date as is practical.

Blindsquirrel

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Re: rental property depreciation recapture in retirement?
« Reply #1 on: June 12, 2014, 07:31:36 PM »
 Actually the IRS will get you for recapture of depreciation whether you claim it or not and whether it saves you any money or not. Nice!  We only sell houses on 1031 exchanges when we have held them awhile or if they are flips. My plan is to do that as long as the law allows as the gain rolls forward into the new property. My plan is the cost basis steps up on my death and I and my heirs will never pay a nickle in tax or depreciation recapture. The law will probably change at some point. We have 4 properties that we own outright that have so much gain rolled into them that selling them would be very, very foolish tax wise as in they would take damn near most of the money. Follow the law but the tax man is always the enemy of your stash.
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arebelspy

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Re: rental property depreciation recapture in retirement?
« Reply #2 on: June 12, 2014, 07:33:05 PM »
Can you use up the depreciation somehow (roll more into a Roth each year, having that reduced by the depreciation amount, to make that money tax free to offset that depreciation recapture)?
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sol

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Re: rental property depreciation recapture in retirement?
« Reply #3 on: June 12, 2014, 07:38:25 PM »
Can you use up the depreciation somehow (roll more into a Roth each year, having that reduced by the depreciation amount, to make that money tax free to offset that depreciation recapture)?

A good thought, but no.  We already max our Roth IRAs and our TSP/401k.

arebelspy

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Re: rental property depreciation recapture in retirement?
« Reply #4 on: June 12, 2014, 08:14:04 PM »
Can you use up the depreciation somehow (roll more into a Roth each year, having that reduced by the depreciation amount, to make that money tax free to offset that depreciation recapture)?

A good thought, but no.  We already max our Roth IRAs and our TSP/401k.

No, I mean when you're FIRE'd - rolling over from the 401k to a Roth, use up the depreciation to let you roll over a little extra.
We are two former teachers who accumulated a bunch of real estate, retired at 29, and now travel the world full time with a kid.
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sol

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Re: rental property depreciation recapture in retirement?
« Reply #5 on: June 12, 2014, 09:12:22 PM »
No, I mean when you're FIRE'd - rolling over from the 401k to a Roth, use up the depreciation to let you roll over a little extra.

Still only a good deal (technically a wash) if you're rolling over extra that would have been in the 25% bracket.  I'm hoping to stay far away from there in retirement.

arebelspy

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Re: rental property depreciation recapture in retirement?
« Reply #6 on: June 12, 2014, 09:22:36 PM »
No, I mean when you're FIRE'd - rolling over from the 401k to a Roth, use up the depreciation to let you roll over a little extra.

Still only a good deal (technically a wash) if you're rolling over extra that would have been in the 25% bracket.  I'm hoping to stay far away from there in retirement.

Right, it's still not optimal, but it at least puts it to a little use rather than wasting it completely.
We are two former teachers who accumulated a bunch of real estate, retired at 29, and now travel the world full time with a kid.
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dragoncar

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Re: rental property depreciation recapture in retirement?
« Reply #7 on: June 13, 2014, 10:44:50 AM »
Anyone know how I avoid depreciation recapture for my S&P500 index fund?

;-)

arebelspy

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Re: rental property depreciation recapture in retirement?
« Reply #8 on: June 13, 2014, 11:02:45 AM »
Anyone know how I avoid depreciation recapture for my S&P500 index fund?

;-)

Unfortunately for you, that's not a (generally beneficial) thing you get to take advantage of.  ;)
We are two former teachers who accumulated a bunch of real estate, retired at 29, and now travel the world full time with a kid.
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Nords

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Re: rental property depreciation recapture in retirement?
« Reply #9 on: June 14, 2014, 08:52:13 PM »
Anyone know how I avoid depreciation recapture for my S&P500 index fund?
;-)
That's right up there with depreciating the land under your rental property structure... but I'm sure the IRS would be happy to bring you in to their office for a free consultation!
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jimmylomax

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Re: rental property depreciation recapture in retirement?
« Reply #10 on: February 02, 2016, 09:30:13 PM »
@Sol - did you ever get your answer? I just crawled through quite a few threads (including this one - http://forum.mrmoneymustache.com/real-estate-and-landlording/case-study-sell-the-rental-property-or-keep-it-(help-needed!)/msg314050/#msg314050) and I'm very curious as well. It sounds like I've found myself following your trail. I see you've replied on quite a few similar threads, but I still didn't see what seems to be a great resolution. We're currently in 15% ordinary income bracket until FI when we pretty much plan to stay here or lower... recapturing that depreciation at 25% seems pretty harsh since I took the deduction in the 15% bracket. I downloaded the linked irs p544 (https://www.irs.gov/pub/irs-pdf/p544.pdf) and I actually don't see where it is specified that depreciation is recaptured at a fixed 25% regardless of ordinary income tax bracket, but I've read it enough times on this forum that I assume it is true.


I'm getting pretty good at this tax thing from a personal perspective (big thanks to https://sites.google.com/site/excel1040), but now I think it's time to do a bit more long term thinking and planning. Forgive me for tax-speak is a second language I'm learning, but...
The only "avoidance" answer I've found is the "upREIT" aka 1031/721 Exchange in which you purchase this high yielding dividend investment until you croak. So, I guess you never get to sell and enjoy the appreication; you just reap the fruit from the magic dividend tree.
http://www.exeter1031.com/article_upREIT_1031_721.aspx

Any other options/thoughts? I sure hope I've missed one.

Cathy

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Re: rental property depreciation recapture in retirement?
« Reply #11 on: February 02, 2016, 10:31:14 PM »
... I actually don't see where it is specified that depreciation is recaptured at a fixed 25% regardless of ordinary income tax bracket, but I've read it enough times on this forum that I assume it is true.

That assumption would be a mistake, since it's not true.

Section 1250 of the Internal Revenue Code generally provides that, on the disposition of certain realty (including most residential rental real estate), gains attributable to depreciation adjustments that were "allowed or allowable to the taxpayer or to any other person" are not treated as capital gains but instead "shall be treated as gain which is ordinary income". 26 USC 1250(a)(1)(A). The effect of these provisions is that gains attributable to certain depreciation adjustments would generally be taxed at the taxpayer's ordinary marginal rate. However, another provision of the Code specifies that certain gains attributable to depreciation adjustments are taxed at a maximum of 25%. 26 USC 1(h)(1)(E)(i). The 25% maximum is a gift, not a punishment. It can only lower the amount that the taxpayer would otherwise owe.

Although the above analysis is sufficient, I will also explain where the same information is found in the IRS forms. If a taxpayer has any gains attributable to depreciation adjustments for certain residential rental real estate, those gains are reported on Line 19 of Schedule D to Form 1040. If a taxpayer reports an amount on that line, the instructions indicate that the taxpayer should figure her overall tax using the "Schedule D Tax Worksheet" found at page 15 of the Schedule D Instructions. That worksheet uses a rather complicated calculation to figure the tax, but for our purposes, we can jump to the last line (Line 45) where we see that the calculation chooses whichever is smaller: the normally-calculated tax, or the specially-calculated tax using this complicated worksheet. In other words, the special 25% rate applicable to certain gains can only lower the tax otherwise payable.
« Last Edit: February 02, 2016, 10:39:28 PM by Cathy »
This post contains only general information on the issues raised by this topic. This post does not provide help tailored to your specific situation. There are many facts that could be relevant to your specific situation and I am not in possession of those facts. If you need help tailored to your specific situation, you should retain an appropriate professional and not rely on this post.

sol

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Re: rental property depreciation recapture in retirement?
« Reply #12 on: February 02, 2016, 10:42:37 PM »
@Sol - did you ever get your answer?

No, not really.  Nobody has replied to any of these threads with anything substantive, which leads me to believe that my original interpretation was correct: holding rental property in retirement sucks.  You're forced to take depreciation that is totally worthless to you because you have no tax liability, and then you're taxed at 25% when you sell.

So unless anyone else wants to chip in here to change my mind, my current plan is divest myself of all of our rental property in the year after I retire.  Take the money and run with it.  They're profitable but not wildly so, but the tax hit amounts to several thousand dollars per year in accumulating extra taxes (25% of each year's depreciation amount) that I'll end up paying on my real estate investments that I don't have to pay on my stock investments.  This tilts the scale towards stocks in the great stocks vs RE debate. 

I can see a situation where it might make sense to keep them, if they were hugely cashflow positive, but in general depreciation recapture plus mustachianism seems to be a bad combination.

arebelspy

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Re: rental property depreciation recapture in retirement?
« Reply #13 on: February 02, 2016, 10:58:49 PM »
I believe all that is true sol, except for two statements:
Quote
depreciation that is totally worthless to you because you have no tax liability

All my depreciation is eaten up by my rentals' cash flow, so even if I had no other tax liability, it's still useful (you did mention this caveat in your final sentence).

and

Quote
you're taxed at 25% when you sell

You can, if you choose, never sell, and never pay those taxes as your heirs (or designated charity, or whatever), inherit it on a stepped up basis.

So it's not necessarily always the case that the depreciation is worthless, nor that you'll be taxes at 25% (because you might not sell).

In your case, selling seems like the best answer, however.
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MDM

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Re: rental property depreciation recapture in retirement?
« Reply #14 on: February 03, 2016, 12:22:54 AM »
If Cathy's chapter & verse citations aren't sufficient, there is always the comment of a random poster at Bogleheads, https://www.bogleheads.org/forum/viewtopic.php?t=161082, saying "...the depreciation recapture will be taxed at the minimum of your income tax rate or 25%."

sol

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Re: rental property depreciation recapture in retirement?
« Reply #15 on: February 03, 2016, 12:28:10 AM »
If Cathy's chapter & verse citations aren't sufficient, there is always the comment of a random poster at Bogleheads, https://www.bogleheads.org/forum/viewtopic.php?t=161082, saying "...the depreciation recapture will be taxed at the minimum of your income tax rate or 25%."

I was under the impression that only applied to the capital gains portion, if the property sold for more than you bought it for, and that the 25% rate applied to all depreciation between current cost basis and your original purchase price.   

Please tell me I'm mistaken.  I want to be mistaken.

Cathy

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Re: rental property depreciation recapture in retirement?
« Reply #16 on: February 03, 2016, 12:37:17 AM »
Please tell me I'm mistaken.  I want to be mistaken.

As explained in my post above, the 25% maximum rate applicable to certain gains attributable to depreciation adjustments is a gift from Congress, an act of legislative grace. The provision of that rate can only ever lower the taxes that you would otherwise pay. There is no situation where it will cause you to pay more taxes than you would otherwise pay, contrary to apparent common belief on this forum.
This post contains only general information on the issues raised by this topic. This post does not provide help tailored to your specific situation. There are many facts that could be relevant to your specific situation and I am not in possession of those facts. If you need help tailored to your specific situation, you should retain an appropriate professional and not rely on this post.

cchrissyy

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Re: rental property depreciation recapture in retirement?
« Reply #17 on: February 03, 2016, 12:37:36 AM »
But if you never sell, this will never happen, right?

jwright

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Re: rental property depreciation recapture in retirement?
« Reply #18 on: February 03, 2016, 07:41:55 AM »
If Cathy's chapter & verse citations aren't sufficient, there is always the comment of a random poster at Bogleheads, https://www.bogleheads.org/forum/viewtopic.php?t=161082, saying "...the depreciation recapture will be taxed at the minimum of your income tax rate or 25%."

I was under the impression that only applied to the capital gains portion, if the property sold for more than you bought it for, and that the 25% rate applied to all depreciation between current cost basis and your original purchase price.   

Please tell me I'm mistaken.  I want to be mistaken.

You are mistaken; see Cathy's response.  25% is the maximum.

brooklynguy

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Re: rental property depreciation recapture in retirement?
« Reply #19 on: February 03, 2016, 08:18:28 AM »
I believe all that is true sol, except for two statements:

Quote
depreciation that is totally worthless to you because you have no tax liability

All my depreciation is eaten up by my rentals' cash flow, so even if I had no other tax liability, it's still useful (you did mention this caveat in your final sentence).

Also, depreciation can be helpful in enabling you to qualify for or maximize any potentially available income-based means-tested benefits.  ACA credits/subsidies are the most salient in my mind, but there are lots of others, like tuition assistance, etc.  So even if you have zero tax liability, depreciation can enable you to render your tax liability negative, or receive non-tax-related financial benefits for which you otherwise would not have qualified.

It's highly situation-dependent, though, so everyone needs to run their own numbers carefully.  In sol's case, if the rental real estate were swapped for stocks immediately after retirement, it might take a long time for the cost basis in the stocks to diminish enough to tip the scales back in favor of depreciable rental real estate, depending on his overall financial profile.

jimmylomax

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Re: rental property depreciation recapture in retirement?
« Reply #20 on: February 03, 2016, 02:34:25 PM »
Thanks team. I've never been so impressed with such a prompt and robust reply to any forum post I've ever created anywhere. I guess Sol put a bit of a lightning rod into it as well.

For me I'm all for the interest free loan that is depreciating my property - especially if, in the worst case, I have to recapture it (and now mostly in a lower bracket). Any thoughts on if that recapture can be divided over some number of years? I would think it would follow in the same way gains taxes can be spread out in this way.

I agree I will probably hold the property indefiitely and if I get tired of managing it and don't want to pay someone else to manage this specific property, I will look in to the upREIT.


bacchi

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Re: rental property depreciation recapture in retirement?
« Reply #21 on: February 03, 2016, 03:34:35 PM »
Please tell me I'm mistaken.  I want to be mistaken.

As explained in my post above, the 25% maximum rate applicable to certain gains attributable to depreciation adjustments is a gift from Congress, an act of legislative grace. The provision of that rate can only ever lower the taxes that you would otherwise pay. There is no situation where it will cause you to pay more taxes than you would otherwise pay, contrary to apparent common belief on this forum.

Please elaborate.

If I depreciate $5000 a year at my current marginal 15% bracket, I reduce my income taxes by $750.

I do this for 20 years and then sell at a profit. That year, I have to recapture $100,000. If my 15% bracket is filled by other income, the $100,000 is recaptured at the next bracket, which is 25%.

Ignoring the time value of money, I reduced my tax bill by $15k (750*20) but paid $25,000 at the end.

What am I missing?

MDM

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Re: rental property depreciation recapture in retirement?
« Reply #22 on: February 03, 2016, 03:47:13 PM »
What am I missing?

Nothing, in terms of estimating your actual tax bracket when recapturing the depreciation.

If that happens to be 25%, that is the rate you will pay on the recapture amount.

The main point of the thread is that you will pay no more than 25% on the recapture amount if you are in a higher tax bracket for ordinary income, and will pay less than 25% if you are in a lower tax bracket for ordinary income.

Make sense?

bacchi

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Re: rental property depreciation recapture in retirement?
« Reply #23 on: February 03, 2016, 03:53:37 PM »
What am I missing?

Nothing, in terms of estimating your actual tax bracket when recapturing the depreciation.

If that happens to be 25%, that is the rate you will pay on the recapture amount.

The main point of the thread is that you will pay no more than 25% on the recapture amount if you are in a higher tax bracket for ordinary income, and will pay less than 25% if you are in a lower tax bracket for ordinary income.

Make sense?

Ah, got it. I misunderstood. Thanks.

fishnfool

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Re: rental property depreciation recapture in retirement?
« Reply #24 on: February 03, 2016, 08:48:30 PM »
Can you avoid recapture by moving into your rental?

jimmylomax

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Re: rental property depreciation recapture in retirement?
« Reply #25 on: February 04, 2016, 07:20:15 AM »
Can you avoid recapture by moving into your rental?

I had essentially this same question since I lived in one of my quadplex units the last 5 years, but I think I understand it well enough. You do not depreciate the portion in which you live while you are living there. So, in this way you are correct. In other words in my case, if I lived there for 5 years starting when I purchased it and then owned it for 20 more before selling and then do not do a 1031 exchange of some kind such that I must recapture the depreciation... I'm going to recapture, or essentially "pay back", the depreciation I took at 3/4ths for 5 years and then 4/4ths for 20 years for the difference between initial basis (or [edit 2/9/16: Improved portion of] final sale price if less than initial basis) and depreciated end-basis. And as established, it will be based on your marginal tax bracket with the additional benefit of a 25% cap.

I think my only lingering question is whether or not I have to take that hit all in one year or if I can recapture it over multiple tax years - so as to effectively keep from crossing over the 15%/25% tax bracket threshold each year until all depreciation has been recaptured.

------------------
edit 2/9/16 - despite numerous edits, I'm still correcting this post to try and get it closer to "right". I know it still isn't but I think the fundamentals are there. This is why you pay your lawyers and accounts the best! Above I tried to take into account the fact that you do not depreciate the land - so I don't think it is so simple to say you'd recapture all the way up to final sale price if less than intial basis. When you initially file your taxes and start taking depreciation, you establish proportion of land vs. improved value (building(s)). So at sale I am guessing you will perform the same analysis to indicate at final sale date percentage of land vs. improvements and then calculate your difference for recapture from that amount.
« Last Edit: February 09, 2016, 02:00:29 PM by jimmylomax »

Bearded Man

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Re: rental property depreciation recapture in retirement?
« Reply #26 on: February 07, 2016, 10:05:30 PM »
Following.

Goldielocks

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Re: rental property depreciation recapture in retirement?
« Reply #27 on: February 07, 2016, 10:38:38 PM »
@Sol - did you ever get your answer?

No, not really.  Nobody has replied to any of these threads with anything substantive, which leads me to believe that my original interpretation was correct: holding rental property in retirement sucks.  You're forced to take depreciation that is totally worthless to you because you have no tax liability, and then you're taxed at 25% when you sell.

So unless anyone else wants to chip in here to change my mind, my current plan is divest myself of all of our rental property in the year after I retire.  Take the money and run with it.  They're profitable but not wildly so, but the tax hit amounts to several thousand dollars per year in accumulating extra taxes (25% of each year's depreciation amount) that I'll end up paying on my real estate investments that I don't have to pay on my stock investments.  This tilts the scale towards stocks in the great stocks vs RE debate. 

I can see a situation where it might make sense to keep them, if they were hugely cashflow positive, but in general depreciation recapture plus mustachianism seems to be a bad combination.
Canadian tax system is typically very similar to the US system in most things.

Here, we can choose whether or not to claim CCA (capital cost allowance, or depreciation) as a business expense,each year, and how much of it we claim up to the max percentage allowed.  Many people with only one rental do NOT infact claim depreciation on rental property for the hassle reason you mention,  there is no point if the asset is appreciating in real life and you don't need to defer taxes.

Are you certain you are forced to claim it if you would rather  not?

Lastly, although often overshadowed by the rising property values, there is normally some benefit to defer taxes even if the tax rate is equal.  A dollar today is worth far more to you than a dollar 14 years from now....

Ebrat

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Re: rental property depreciation recapture in retirement?
« Reply #28 on: February 08, 2016, 11:17:03 AM »
Can you avoid recapture by moving into your rental?

I had essentially this same question since I lived in one of my quadplex units the last 5 years, but I think I understand it well enough. You do not depreciate the portion in which you live while you are living there. So, in this way you are correct. In other words in my case, if I lived there for 5 years starting when I purhased it and then owned it for 20 more before selling and then do not do a 1031 exchange of some kind such that I must recapture the depreciation... I'm going to recapture, or essentially "pay back", the depreciation I took at 3/4ths for 5 years and then 4/4ths for 20 years for the difference between initial basis (or final sale price if less than initial basis) and depreciated end-basis. And as established, it will be based on your marginal tax bracket with the additional benefit of a 25% cap.

I think my only lingering question is whether or not I have to take that hit all in one year or if I can recapture it over multiple tax years - so as to effectively keep from crossing over the 15%/25% tax bracket threshold each year until all depreciation has been recaptured.

I looked into this because I was wondering the same thing.  Looks like you still have to pay depreciation recapture when/if you sell:  http://articles.chicagotribune.com/2013-09-29/marketplace/sns-201305312000--tms--realestmctnig-a20130609-20130609_1_investment-property-tax-implications-tax-deferred-exchange (I also found something on the IRS site that said the same thing, but I can't find it now)

jimmylomax

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Re: rental property depreciation recapture in retirement?
« Reply #29 on: February 09, 2016, 02:15:28 PM »
Can you avoid recapture by moving into your rental?

I had essentially this same question since I lived in one of my quadplex units the last 5 years, but I think I understand it well enough. You do not depreciate the portion in which you live while you are living there. So, in this way you are correct. In other words in my case, if I lived there for 5 years starting when I purhased it and then owned it for 20 more before selling and then do not do a 1031 exchange of some kind such that I must recapture the depreciation... I'm going to recapture, or essentially "pay back", the depreciation I took at 3/4ths for 5 years and then 4/4ths for 20 years for the difference between initial basis (or final sale price if less than initial basis) and depreciated end-basis. And as established, it will be based on your marginal tax bracket with the additional benefit of a 25% cap.

I think my only lingering question is whether or not I have to take that hit all in one year or if I can recapture it over multiple tax years - so as to effectively keep from crossing over the 15%/25% tax bracket threshold each year until all depreciation has been recaptured.

I looked into this because I was wondering the same thing.  Looks like you still have to pay depreciation recapture when/if you sell:  http://articles.chicagotribune.com/2013-09-29/marketplace/sns-201305312000--tms--realestmctnig-a20130609-20130609_1_investment-property-tax-implications-tax-deferred-exchange (I also found something on the IRS site that said the same thing, but I can't find it now)


I think we're both right, but somewhat answering different questions. I'm quite sure living in the rental property will reduce the total amount of depreciation you would otherwise be forced to take and, in our seemingly worst-case example, recapture. But yes, referring to my own example, I will certainly still be on the hook for all the depreciation I did take while I wasn't living there.

The way I think of it is: if I paid $100k for a property and declared 20% to be land. I would depreciate $80k over 27.5 years if I never lived there. If I lived there for 2.75 years (10% of duration), then the most I would ever depreciate, and therefore be required to recapture would be 90% of 80k which is $72k. This assumes that after selling in >27.5 years the improved value at time of sale which was split 80/20 is now greater than $80k (regardless of the Improved/land ratio).
« Last Edit: February 09, 2016, 02:22:36 PM by jimmylomax »

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Re: rental property depreciation recapture in retirement?
« Reply #30 on: February 09, 2016, 02:34:52 PM »
Ignoring the time value of money
Quote
What am I missing?
To me, that's the main thing that matters. Why would you ignore it?
Invest the savings in an index fund, you have the $10K in less than a decade and more like $30K by the end.
Reinvest in real estate, where I assume you're beating the stock market or you wouldn't be there to begin with, and beat the spread by even more.
All that, of course, is assuming you actually pay more, which has already been established as a big "maybe". If you're earning enough in FIRE to pay 25% on ordinary income, you're probably not worried about tax rates, nor are you selling a profitable rental.
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Re: rental property depreciation recapture in retirement?
« Reply #31 on: February 09, 2016, 07:32:06 PM »
Can you avoid recapture by moving into your rental?

I had essentially this same question since I lived in one of my quadplex units the last 5 years, but I think I understand it well enough. You do not depreciate the portion in which you live while you are living there. So, in this way you are correct. In other words in my case, if I lived there for 5 years starting when I purhased it and then owned it for 20 more before selling and then do not do a 1031 exchange of some kind such that I must recapture the depreciation... I'm going to recapture, or essentially "pay back", the depreciation I took at 3/4ths for 5 years and then 4/4ths for 20 years for the difference between initial basis (or final sale price if less than initial basis) and depreciated end-basis. And as established, it will be based on your marginal tax bracket with the additional benefit of a 25% cap.

I think my only lingering question is whether or not I have to take that hit all in one year or if I can recapture it over multiple tax years - so as to effectively keep from crossing over the 15%/25% tax bracket threshold each year until all depreciation has been recaptured.

I looked into this because I was wondering the same thing.  Looks like you still have to pay depreciation recapture when/if you sell:  http://articles.chicagotribune.com/2013-09-29/marketplace/sns-201305312000--tms--realestmctnig-a20130609-20130609_1_investment-property-tax-implications-tax-deferred-exchange (I also found something on the IRS site that said the same thing, but I can't find it now)


I think we're both right, but somewhat answering different questions. I'm quite sure living in the rental property will reduce the total amount of depreciation you would otherwise be forced to take and, in our seemingly worst-case example, recapture. But yes, referring to my own example, I will certainly still be on the hook for all the depreciation I did take while I wasn't living there.

The way I think of it is: if I paid $100k for a property and declared 20% to be land. I would depreciate $80k over 27.5 years if I never lived there. If I lived there for 2.75 years (10% of duration), then the most I would ever depreciate, and therefore be required to recapture would be 90% of 80k which is $72k. This assumes that after selling in >27.5 years the improved value at time of sale which was split 80/20 is now greater than $80k (regardless of the Improved/land ratio).

Yeah, that sounds right.  I think I was initially tripped up because you're talking about a quadplex and I have a SFR.  But the issues sound the same.  I suspect you have to take the depreciation recapture all at once, which sucks because we've been in the 15% tax bracket in the past but are now in the 25% tax bracket, so if we sell in our current circumstances we'll be paying more in depreciation recapture than we actually saved with the depreciation when we were in a lower tax bracket.  (We're currently planning to hang onto it, though, and hopefully move back into it someday.)

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Re: rental property depreciation recapture in retirement?
« Reply #32 on: February 09, 2016, 09:46:05 PM »
posting to follow...

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Re: rental property depreciation recapture in retirement?
« Reply #33 on: February 10, 2016, 06:59:38 AM »
Talk to a real estate tax accountant.

If the gain of your property was due to the land appreciating, the depreciation does not have to be recaptured.  But a property for $200K ($20K land, $180K building), depreciate $100K, sell it for $200K ($140K land, $60K building).

You do not have to recapture the entire 100K.  You may not recapture anything.  You have a $20K loss.

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Re: rental property depreciation recapture in retirement?
« Reply #34 on: February 10, 2016, 08:26:19 AM »
If the gain of your property was due to the land appreciating, the depreciation does not have to be recaptured.

This is an intriguing point.  In all the depreciation/recapture discussions that I've seen, there seems to be a default underlying assumption that the ratio of land value to building/improvements value always remains constant.  But, absent special circumstances, shouldn't any appreciation in total property value be mostly (or wholly) attributable to appreciation in the land value itself?  In theory, that's consistent with the rationale behind the allowability of real estate depreciation deductions in the first place (i.e., buildings/improvements wear out, become obsolete and/or get used up, but land itself does not).

Question for the seasoned real estate pros:  is it common to use a different breakdown between land value and building/improvements value for purposes of recapture than the breakdown originally used for purposes of depreciation?  If so, how is the difference established and supported?  An appraisal conducted at the time of the sale showing a different breakdown than the breakdown that existed according to an appraisal conducted at the time of the original purchase?

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Re: rental property depreciation recapture in retirement?
« Reply #35 on: February 10, 2016, 11:38:04 AM »
I glossed over this in my earlier post, but I should also point out that this forum commonly misuses the word "recapture".

Generally speaking, on the disposition of certain buildings held for more than one year, depreciation recapture applies only to the portion of the gains attributable to depreciation adjustments to the extent that such depreciation adjustments "exceed the amount of the depreciation adjustments which would have resulted if such adjustments had been determined for each taxable year under the straight line method of adjustment". 26 USC 1250(b)(1). Depreciable residential buildings are generally depreciated using the straight line method, 26 USC 168(b)(3)(B), although there are certain exceptions.

Even though these straight line depreciation adjustments to certain residential buildings held for more than one year are not subject to recapture, they still reduce the cost basis of the property, 26 USC 1016(a)(2), and as such, they may cause the taxpayer to have a "[g]ain[] derived from dealings in property", 26 USC 61(a)(3), simply because of the difference between the cost basis and the disposition price of the property (or maybe not, as NoNonsenseLandlord points out). The tax code refers to such a gain as an "unrecaptured section 1250 gain", 26 USC 1(h)(6)(A) (emphasis added), and, as mentioned, it is subject to tax at a maximum rate of 25%. 26 USC 1(h)(1)(E)(i).

Many of these threads actually discuss principally the taxation of unrecaptured gains attributable to depreciation adjustments, as opposed to the recapture of depreciation adjustments.
« Last Edit: February 10, 2016, 11:50:45 AM by Cathy »
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Re: rental property depreciation recapture in retirement?
« Reply #36 on: February 10, 2016, 12:42:43 PM »
this forum commonly misuses the word "recapture"

I wouldn't go that far -- as you described in the third paragraph of your post, we're using the word "recapture" to describe the taxation of amounts that previously escaped taxation (as a result of depreciation deductions), which is an appropriate use of the word even though it differs from the labels used by the tax code (though your point is well taken that that discrepancy in word usage could easily lead to confusion and should perhaps therefore be avoided).

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Re: rental property depreciation recapture in retirement?
« Reply #37 on: February 10, 2016, 12:49:59 PM »
Talk to a real estate tax accountant.

If the gain of your property was due to the land appreciating, the depreciation does not have to be recaptured.  But a property for $200K ($20K land, $180K building), depreciate $100K, sell it for $200K ($140K land, $60K building).

You do not have to recapture the entire 100K.  You may not recapture anything.  You have a $20K loss.
Every time I have seen that done, the original purchase price of the land and building were declared as ACB, then the building portion only depreciated.
e.g.  if you have ACB of $200k land + $100k Building, and use 4% depreciation on the building, you only depreciate $4k per year... not the full $12k....

Not sure how you would change this original ACB declaration, after 7 or more years of ownership, if you were previously depreciating on the full amount...  a series of tax return revisions for each year in question?
« Last Edit: February 10, 2016, 01:03:58 PM by goldielocks »

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Re: rental property depreciation recapture in retirement?
« Reply #38 on: February 10, 2016, 12:56:46 PM »
Thanks team. I've never been so impressed with such a prompt and robust reply to any forum post I've ever created anywhere. I guess Sol put a bit of a lightning rod into it as well.

For me I'm all for the interest free loan that is depreciating my property - especially if, in the worst case, I have to recapture it (and now mostly in a lower bracket). Any thoughts on if that recapture can be divided over some number of years? I would think it would follow in the same way gains taxes can be spread out in this way.

I agree I will probably hold the property indefiitely and if I get tired of managing it and don't want to pay someone else to manage this specific property, I will look in to the upREIT.
With some asset classes, you hold the CCA and  UCB as a yearly value for the entire lot, including net adds / sales.    (e.g., office furniture) as class, and not recapture until you have eliminated ALL the assets, including more recent purchases.

However, here, the real property (rentals) need to be tracked as their own separate asset pool by address, so recapture happens all at once upon the sale. 
-------------------
Also, rental owners that create a business trust, and hold the properties within the trust, have more options about disposition, for example, selling the company ownership instead of selling each title (to avoid property transfer tax), applying recapture to the business income, not personal income, etc.  I think there is a way to transfer the business with the ACB and CCA in tact, but I have only read about it a long time ago, so don't know if it applies to partnerships or corporations.
« Last Edit: February 10, 2016, 01:06:25 PM by goldielocks »

Goldielocks

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Re: rental property depreciation recapture in retirement?
« Reply #39 on: February 10, 2016, 01:02:51 PM »
If the gain of your property was due to the land appreciating, the depreciation does not have to be recaptured.

Question for the seasoned real estate pros:  is it common to use a different breakdown between land value and building/improvements value for purposes of recapture than the breakdown originally used for purposes of depreciation?  If so, how is the difference established and supported?  An appraisal conducted at the time of the sale showing a different breakdown than the breakdown that existed according to an appraisal conducted at the time of the original purchase?
I am not seasoned, but I have seen a few  of the accounting documentation packages-- usually there is a difference in the ratios of land to building from start to end, if a long time has passed and if property value has gained enough.  Determined with appraisal, which you may need to get in readiness for sale anyway..
« Last Edit: February 10, 2016, 01:06:50 PM by goldielocks »

zephyr911

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Re: rental property depreciation recapture in retirement?
« Reply #40 on: February 10, 2016, 01:53:02 PM »
If the gain of your property was due to the land appreciating, the depreciation does not have to be recaptured.

This is an intriguing point.  In all the depreciation/recapture discussions that I've seen, there seems to be a default underlying assumption that the ratio of land value to building/improvements value always remains constant.  But, absent special circumstances, shouldn't any appreciation in total property value be mostly (or wholly) attributable to appreciation in the land value itself?  In theory, that's consistent with the rationale behind the allowability of real estate depreciation deductions in the first place (i.e., buildings/improvements wear out, become obsolete and/or get used up, but land itself does not).

Question for the seasoned real estate pros:  is it common to use a different breakdown between land value and building/improvements value for purposes of recapture than the breakdown originally used for purposes of depreciation?  If so, how is the difference established and supported?  An appraisal conducted at the time of the sale showing a different breakdown than the breakdown that existed according to an appraisal conducted at the time of the original purchase?
I'm not sure I understand the question. You depreciate based on purchase price minus (land value + transactional costs). The IRS generally lets you use your own reasonable estimate for land value. Regardless of what you sell for, you take your adjusted basis, calculate gain or loss (including the portion due to depreciation), and pay taxes based on that.

You don't have to know the ratio of values for land and improvements, starting or ending, and appraisals would only come into play if your assumed beginning land value was questioned and had to be substantiated.

If you get more than you paid for the property, the land probably appreciated, which means the ratio changed, but it doesn't affect the calculations. You should absolutely, always, use the same value for improvements at the beginning and the end, OR the IRS will screw you at sale time for the depreciation you should have claimed, not what you actually claimed.
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brooklynguy

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Re: rental property depreciation recapture in retirement?
« Reply #41 on: February 10, 2016, 03:23:04 PM »
If you get more than you paid for the property, the land probably appreciated, which means the ratio changed, but it doesn't affect the calculations. You should absolutely, always, use the same value for improvements at the beginning and the end, OR the IRS will screw you at sale time for the depreciation you should have claimed, not what you actually claimed.

This directly contravenes NoNonsenseLandlord's post above (which is what led to my question).

Let's use the numbers from his example:

You buy a property for $200K.  Using a reasonable method, you determine that $20K of that value is attributable to the land, and $180K is attributable to the building.  So the depreciable amount is $180K.  Over time, you depreciate $100K before selling the property for $200K.

If you assume the land-value-to-building-value-ratio remained constant (i.e., that $20K of the sale price is attributable to the land and $180K is attributable to the building), then you have $100K of gain attributable to the reduction in basis caused by depreciation adjustments (or, to use the language of the tax code, "unrecaptured section 1250 gain").  This $100K will be taxed at the lower of (i) your ordinary marginal tax rate and (ii) 25%.

However, if you assume that the land-value-to-building-value ratio changed, you get a different result.  In NoNonsense's example, he assumed the land value appreciated to $140K, while the building value depreciated to $60K.  Now, you have no gains attributable to the reduction in basis caused by depreciation adjustments (instead, you have a $20K loss).

zephyr911

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Re: rental property depreciation recapture in retirement?
« Reply #42 on: February 11, 2016, 11:18:27 AM »
But the appreciation of the land doesn't affect your adjusted basis or your sale price. Regardless of what it was that produced the rise in value, the calculation is going to be the same. Cost basis, adjusted for depreciation, will always be less than sale price even at net zero, unless you spent more on new improvements than you claimed in depreciaton (let's ignore that for the sake of discussion).

In this case, transactional costs aside, sale price is $200k and adjusted basis is $100K, fully attributable to prior depreciation.

BTW, I didn't mean to say that the value of the improvements never changed. I meant that each year's depreciation should be based on the same original value. We're not recalculating value, we're just claiming depreciation and reducing the basis accordingly. And yes, if the value of the structure drops and the property sells for the same price, that implies the land is a higher percentage of the value at sale.

However, I still see the question of ratios as a red herring. Buy the property, calculate the basis, subtract land value, depreciate improvements, adjust basis by equal amount, sell and calculate gains. End. I don't ever have to calculate a ratio to do this correctly. It's like adding a variable to the equation that doesn't affect the end result, and I was never good enough at math to suffer needless complexity.
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brooklynguy

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Re: rental property depreciation recapture in retirement?
« Reply #43 on: February 11, 2016, 01:14:50 PM »
However, I still see the question of ratios as a red herring. Buy the property, calculate the basis, subtract land value, depreciate improvements, adjust basis by equal amount, sell and calculate gains. End. I don't ever have to calculate a ratio to do this correctly. It's like adding a variable to the equation that doesn't affect the end result, and I was never good enough at math to suffer needless complexity.

It's not that you have to calculate the ratio in order to determine the tax consequences; it's that a change in the ratio can have an effect on the tax consequences, as illustrated by NoNonsense's example.

Quote
In [NoNensense's hypothetical] case, transactional costs aside, sale price is $200k and adjusted basis is $100K, fully attributable to prior depreciation.

Right, but your gains/losses will differ depending on the breakdown between land value and building value at the time of the sale.  If the portion of the sale price attributable to the building exceeds your $100k of adjusted basis, you have gains, and if it doesn't, you don't.

zephyr911

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Re: rental property depreciation recapture in retirement?
« Reply #44 on: February 11, 2016, 01:22:02 PM »
It's not that you have to calculate the ratio in order to determine the tax consequences; it's that a change in the ratio can have an effect on the tax consequences, as illustrated by NoNonsense's example.
Okay, so we are in agreement that the ratio itself is merely a consequence of the factors that determine the gain.
Quote
Right, but your gains/losses will differ depending on the breakdown between land value and building value at the time of the sale.  If the portion of the sale price attributable to the building exceeds your $100k of adjusted basis, you have gains, and if it doesn't, you don't.
The breakdown only affects your gain to the extent that it determines depreciation at purchase time. I haven't seen anyone establish how it affects anything else at the time of sale.
Adjusted basis of $100K, sale price of $200K, capital gain $100K.

The land/improvements breakout affects the recapture determination, but not the gain. The gain is just (sale price - (purchase price - depreciation)). At that point it doesn't matter how you got there or what the current value of the land is.
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arebelspy

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Re: rental property depreciation recapture in retirement?
« Reply #45 on: February 11, 2016, 01:40:33 PM »
It's not that you have to calculate the ratio in order to determine the tax consequences; it's that a change in the ratio can have an effect on the tax consequences, as illustrated by NoNonsense's example.
Okay, so we are in agreement that the ratio itself is merely a consequence of the factors that determine the gain.
Quote
Right, but your gains/losses will differ depending on the breakdown between land value and building value at the time of the sale.  If the portion of the sale price attributable to the building exceeds your $100k of adjusted basis, you have gains, and if it doesn't, you don't.
The breakdown only affects your gain to the extent that it determines depreciation at purchase time. I haven't seen anyone establish how it affects anything else at the time of sale.
Adjusted basis of $100K, sale price of $200K, capital gain $100K.

The land/improvements breakout affects the recapture determination, but not the gain. The gain is just (sale price - (purchase price - depreciation)). At that point it doesn't matter how you got there or what the current value of the land is.

In other words, brooklynguy, are you saying if i demolish the building, i don't have to pay back any depreciation?
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Re: rental property depreciation recapture in retirement?
« Reply #46 on: February 11, 2016, 01:42:07 PM »
The breakdown only affects your gain to the extent that it determines depreciation at purchase time. I haven't seen anyone establish how it affects anything else at the time of sale.
Adjusted basis of $100K, sale price of $200K, capital gain $100K.

The land/improvements breakout affects the recapture determination, but not the gain. The gain is just (sale price - (purchase price - depreciation)). At that point it doesn't matter how you got there or what the current value of the land is.

Yes, your overall gain on the sale is $100k.  But the portion of that gain that is attributable to depreciation adjustments will be taxed at your ordinary income rate (capped at 25%), while the balance of the gain will be taxed at the capital gains rate.  And the portion of the gain that is attributable to the depreciation adjustments will depend on the portion of the gain that is attributable to the building as opposed to the land.  So the land/building breakdown at the time of the sale does matter for purposes of determining your tax liability as a result of the sale.  That was NoNonsense's point, which I had never seen raised before.

brooklynguy

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Re: rental property depreciation recapture in retirement?
« Reply #47 on: February 11, 2016, 01:52:18 PM »
In other words, brooklynguy, are you saying if i demolish the building, i don't have to pay back any depreciation?

Yes, if you demolish the building, then it would seem that you have a rock-solid argument that the entire $200k sale price is attributable to the land, which means you have no gains attributable to the depreciation adjustments (i.e., there is no depreciation to be "recaptured" in the sense we usually use that word (though, as Cathy points out, that usage is not consistent with the tax code)).

But that's why, after reading NoNonsense's post, I questioned whether this is a common scenario in practice (where, short of building demolition, you avoid depreciation "recapture" by establishing that the value of the building went down, even though your total land + building sale price was higher than your total land + building purchase price).

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Re: rental property depreciation recapture in retirement?
« Reply #48 on: February 11, 2016, 02:11:30 PM »
In case there's any doubt on this point, Crane v. Commissioner, 331 US 1 (1947) is authority for the proposition that the ratio of land value to building value can be different at sale compared to acquisition. It is not the main point of the case, but in passing the Supreme Court says the following:

                  The original basis [of the property] was $262,042.50, its appraised value in 1932. Of this value $55,000.00 was allocable to land and $207,042.50 to building. During the period that petitioner held the property, there was an allowable depreciation of $28,045.10 on the building, so that the adjusted basis of the building at the time of sale was $178,997.40. ... The [1938] selling price [of $257,500.00] was allocable in the proportion, $54,471.15 to the land and $203,028.85 to the building.
331 US at 4 (footnote markers omitted).

In this particular example, the acquisition and sale ratios differ from each other by less than 1%, but they are not the same.
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Re: rental property depreciation recapture in retirement?
« Reply #49 on: February 12, 2016, 04:54:05 AM »
Can someone explain to me what an Upreit is?  I goggled it, but the language was so complex that I really couldn't understand it.  I fault my 62 yo brain!  We would love to sell our single-family rental so as not to have to deal with it in old age, but I don't know if this upreit would be something we could use?

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