Help me understand depreciation and recapture

[stepingum]

New landlord here renting out what was our primary residence while living abroad for two years. When we return to the states we have no set plans whether we will move back into that place, buy or rent a different one and keep house #1 rented out or sell it. So, lots of variables and flexibility, and understanding depreciation and recapture will help form our plan going forward. We are currently low income at least until our two toddlers start school, and if we can make the numbers work, we might continue to be low income after moving home.

Self-employed Gross take-home $30k
Rental gross $24k with about $12k written off. No major expenses expected (updated with new appliances, new roof, new septic). Cash flows +$500 per month.

When I filed 2018 taxes I followed depreciation tables, not understanding we would have to pay income tax on that recapture someday. The question is, we are so low income right now, and don't know if we will continue to be when we might sell someday, so would we be wiser not to depreciate? I guess I don't understand how depreciation works out as very beneficial for anyone unless they never intend to sell...I must be missing something?!

I think I understand the capital gains rules and we'll definitely keep those in mind when deciding how to proceed.

Somewhat unrelated, but we are also trying to wrap our heads around the Foreign Earned Income Exclusion and EITC, as they are mutually exclusive. Basically, there are a few different avenues we can take that result in paying very little, if any, taxes while living abroad and low income.

[secondcor521]

The question is, we are so low income right now, and don't know if we will continue to be when we might sell someday, so would we be wiser not to depreciate? I guess I don't understand how depreciation works out as very beneficial for anyone unless they never intend to sell...I must be missing something?!

No, it would not be wiser not to depreciate.  The reason for this is that if you look at the fine print on recapture taxes, you have to pay recapture taxes on what you *could have taken* in depreciation, not what you *did take* in depreciation.  So forgoing depreciation now doesn't excuse you from recapture taxes later.  Yes, if you're low income now, the depreciation may not be helping you much.  But some help is better than no help.

Depreciation and recapture sort of function as tax deferral / tax rate arbitrage.  If you can depreciate when you're in a high bracket (maybe working a high paying full time job while doing rental real estate as a side gig) and recapture when you're in a low bracket (maybe after you've retired early), then you capture that rate arbitrage.  And in the meantime, you can put those taxes that you didn't pay for a while to work, either in capital improvements, or cash flow, or whatever.

Also, I think, but am not certain, that there are ways to avoid recapture taxes.  Perhaps there is some sort of excuse if you hold onto the property until death.  Maybe 1031 exchanges come into play.  I'm not as certain there; I'm not into rental real estate myself.

[stepingum]

I guess that's a no-brainer then! So renting out a house really complicates our taxes between now and forever 😏. Charming. We were pretty lax in tracking improvements for the first five years the house was our primary, but I'll start combing through statements I guess.

I also figured out the EITC only applies when children reside with you WITHIN the US for at least six months of the year, so it won't apply this year, but if we move back prior to July 1, 2020 it will next year. What a mess.

[monarda]

We plan to just pay the large tax bill this year. We have 11 years of depreciation to recapture, it's not going to be too bad. Still better than not having rented it out. That will probably be the case for you, too.

[SeattleCPA]

The actual depreciation recapture equals greater of what you should have taken or did take btw...

Also, be sure you understand how Sec 121 works (exclusion of gain on sale of primary residence)... about the worst thing you can do as a real estate investor is give up a big heaping helping of tax-free gain on primary residence by turning former residence into a rental.

In some situations, you can almost argue you should sell your primary residence for tax-free gain and then buy the identical house across the street for rental with proceeds...

[stepingum]

The actual depreciation recapture equals greater of what you should have taken or did take btw...

Also, be sure you understand how Sec 121 works (exclusion of gain on sale of primary residence)... about the worst thing you can do as a real estate investor is give up a big heaping helping of tax-free gain on primary residence by turning former residence into a rental.

In some situations, you can almost argue you should sell your primary residence for tax-free gain and then buy the identical house across the street for rental with proceeds...

Thank you! Sec 121 is the capital gains rule that states we must live there as our primary residence for at least 2 of the 5 years prior to the sale in order to avoid paying capital gains tax (up to $500k, I believe), correct? We are nearly one year into it being a rental, so we should decide whether to sell or move back into it within two years. To be honest, I don't have a good feel for where we might be at, in terms of capital gains...

[SeattleCPA]

In a nutshell, the Section 121 angle means you shouldn't convert a primary residence that's massively appreciated in value into a rental. Rather, you should use the Section 121 exclusion of gain to avoid paying taxes.