Can you avoid recapture by moving into your rental?
Hi, I think I can help clarify this one. As I understand it, the depreciation you claim over time simply acts to lower the effective purchase price of the property (not land) for calculation of any capital gains. When you sell, the capital gain (assuming you don't roll it over into another rental) is calculated according to this artificial lower 'purchase price' (ie the actual purchase price less the accumulated depreciation). It's almost as if the depreciation is like an IRA contribution into the equity of the house - tax deductible, but taxable later.
BUT lets say you move into the house and live in it as your primary residence for at least 2 years. Now if you sell, yes, the depreciation is taken into account. But because it's your primary residence you get $250,000 of tax free capital gain, and if you own it with your spouse they also get $250,000 tax free too. Thus, if there are two of you, you can still get a load of tax free capital gain. If the house less depreciation has still appreciated by more than $500,000k then yeah, pay some taxes you lucky lucky property owner.
No no no no no...
This was changed like 7 years ago.
Do not spread this information, it's wrong.
The gains are prorated based on the amount of time it was a rental versus primary residence. You don't get the 250/500 exemption anymore, and haven't for a long time.
ARS,
Thanks for raining all over my imaginary tax parade with the truth. Damn you facts!
Yes, the above simplification is totally WRONG, I just so wanted it to be true... however, you do get the 250/500k exemption sort of... but it doesn't indeed extend to the rental period.
Having now done a
lot bit more research into this, it seems to work like this (this is a very simplified version - it gets waaaaay more complicated* outside this most basic example, but this gives me a good idea of the main drivers):
[NOTE this example has been corrected to account for the correct way to division between rental and residential gain, as pointed out by brooklynguy later in this thread]
Let's assume we buy a property for $250,000 [land $50k, house $200k] and rent it out for 5 years at a monthly rent of 2,500 (the '1% rule') with 50% expense ratio. Later, we then move into the property and live in it for 2 years. The house is then sold for $500,000. We'll assume the land/house ratio stayed the same.
With a 27.5 year flatline depreciation rate (residential) our first 5 years renting were:
- Building value: $200k
- Rent recieved: $30k
- Expenses: $15k
- Depreciation $7272
Taxable income from rent = $7728
Assuming a marginal tax rate of 25%, you'd pay tax of $1932. Hey what a deal right? You earned $15k a year for 5 years and only paid tax at 12.88%! Party on!
BUT, the tax man comes back...
We now sell the house for a sweet $500k net (after all allowable expenses from the sale process). The base value for capital gains however is now less than the actual purchase price
(because of that depreciation whether we took it or not) by 5 x $7272 = $36,360.
Realised: $500,000 Adjusted base: $213640 Capital gain: $286,360
Recaptured depreciation is now taken and taxed at a special rate (maximum 25%): so $36,360 taxed at 25% = $9,090 tax
Of the
remaining gain 286,360 - 36,360 = 250,000 5/7 is allocated to the rental period = $178571, 2/7 to your personal residence period = $71428
Remaining rental cap gain: $178571 taxed at 15% = $26785 tax
The cap gain from when you lived there is excluded as you've got an exemption of $250,000, so no tax there.
So you'll owe the tax man $35,875*.
If we'd never rented it out, all that capital gain would have been tax free (because of the 250k exemption), and we'd have cleared $250k. By renting it, we got a total income of $75,000 and a gross capital gain of $250k, but paid a total of $9660 + $9090 + $26785 = $45535 in taxes to clear $279,464. So after taxes, you could say we only made an effective net rental income of $5893/year (279k-250k / 5 years), thereby paying an
effective tax rate on that rental income of 60.7%.
Ouch.
So I conclude Sol is correct, the accumulated depreciation (whether you used it or not) is 'recaptured' at a tax rate of 25%*. And the residual capital gain on the property is apportioned between time it was rented vs time it was your residence. That part can't be excluded, and so you'll owe tax at 15% (long term capital gain rate) on that. Living in the property for a couple of years sure helped a bit - protecting $71k from tax - but it didn't really prevent a massive tax hit. Hence the popularity of 1031 exchanges, which defer all those nasty taxes.
sorry for the bad news.
*
NOTE II
There are many complications that can effect this simplistic hypothetical. YMMV - especially because of different taxable income levels and capital gains tax rates at the time of renting and selling, accumulated passive activity losses, other capital losses, other rental properties, 1031 exchanges, whether you have active participation in your renting, single vs married, etc etc etc. Keep good records, always include your depreciation in your tax returns, and except in very simplistic situations I think it's likely worth it to consult an experienced real estate tax CPA.