Are you required to take depreciation on real estate?

[kenmoremmm]

I've heard it said many times that you should always take depreciation on your real estate assets because even if you don't the IRS will assume that you did. Is this true?

For example, if you're in the 22% or 24% tax bracket, but then you have to pay depreciation recapture at 25%, you lose, so can you just skip claiming the depreciation altogether? I know I'm ignoring the time-value of money concept, but I'm looking at real estate with hold periods of 5 years via syndicated deals.

[MoseyingAlong]

Yes, you should take it.
Whether or not you deduct the depreciation, you are required to recapture it when you sell. The phrasing is "allowed or allowable depreciation."

Not exactly your situation but for a quick example.


From https://www.irs.gov/faqs/sale-or-trade-of-business-depreciation-rentals/depreciation-recapture/depreciation-recapture-3

"Question
I have a home office. Can I deduct expenses like mortgage, utilities, etc., but not deduct depreciation so that when I sell this house the basis won't be affected?
Answer

Regular Method - No. All allowed or allowable depreciation must be considered at the time of sale. You can generally figure depreciation on the business use portion of your home up to the gross income limitation, over a 39-year recovery period and using the mid-month convention. As long as you determine actual expenses and the correct amount of allowed or allowable depreciation, the depreciation reduces the basis of your home accordingly, whether or not you actually claim it on your tax return.... "

[SeattleCPA]

I've heard it said many times that you should always take depreciation on your real estate assets because even if you don't the IRS will assume that you did. Is this true?

For example, if you're in the 22% or 24% tax bracket, but then you have to pay depreciation recapture at 25%, you lose, so can you just skip claiming the depreciation altogether? I know I'm ignoring the time-value of money concept, but I'm looking at real estate with hold periods of 5 years via syndicated deals.

It doesn't work this way. You'd paid 25% tax on the unrecaptured Section 1250 gain--which is what you're talking about--only if your marginal rate was more than 25%.

Also, you probably shouldn't be taking depreciation-generated loss deductions anyway on the syndicated investments because those were passive. So probably you have suspended passive losses that'll shelter your gain.

Also, @MoseyingAlong is right. For what that's worth.

[kenmoremmm]

thanks all.

all these syndications preach the benefit of bonus depreciation which is basically depreciation that is determined through a cost segregation study and then front loaded into your tax returns. you can put 100% of the bonus depreciation into year 1 returns from your k-1 if you like. thus, you get a paper loss for a while.

@SeattleCPA are you saying that when you pay depreciation recapture, that you will only pay up to your marginal tax rate or a max of 25%?

[katsiki]

Is this about rental real estate? ie not primary home

[kenmoremmm]

this is about rental, or in my specific case, syndicated commercial real estate deals.

[katsiki]

Thanks @kenmoremmm !  Just wanted to be sure...

[SeattleCPA]

thanks all.

all these syndications preach the benefit of bonus depreciation which is basically depreciation that is determined through a cost segregation study and then front loaded into your tax returns. you can put 100% of the bonus depreciation into year 1 returns from your k-1 if you like. thus, you get a paper loss for a while.

@SeattleCPA are you saying that when you pay depreciation recapture, that you will only pay up to your marginal tax rate or a max of 25%?

This doesn't make a lot of sense to me. For several reasons.

First, you need to materially participate in an activity to deduct losses. Otherwise the passive loss limitation rules kick in. So I don't think you should have been able to use passive losses from real estate depreciation to shelter ordinary income.

Second, the real estate depreciation isn't recaptured. But it's treated as something called "unrecaptured Section 1250 gain"... and unrecaptured Section 1250 gain rule basically sets a 25% ceiling on the gain you later realize due to real estate depreciation.

Third, the cost segregation study thing. Okay so what that means is that you've got possibly a bunch of personal property that was bonus depreciated. Again, that's probably a passive loss so seems like that shouldn't have been taken. But in any case, that depreciation doesn't result in "unrecaptured Section 1250 gain." The depreciated property was personalty not realty. So there the gain from depreciation results in Section 1245 recapture. This is also called Section 1231 gain... basically though it means that income is recaptured as ordinary income.

Bottomline: You need to have someone who understands all this stuff handle your return? Or you want to do a bunch of research.

Again, though, I can't figure out how you got around the material participation rules which should have prevented you from taking the depreciation-generated losses.

[kenmoremmm]

@SeattleCPA
i PM'd you some info with some videos. if you watch, maybe your viewing will be able to simplify what i'm trying to say. here's my takeaway:

the TCJA allowed for bonus depreciation to be placed 100% in year 1 of a property. so, after doing a cost seg study, you get all this paper loss front loaded rather than stretched out over 39 years for commercial real estate. the syndication distributes the paper loss to the passive investors allocated as a percent ownership. in subsequent years of holding the syndication, or your other real estate positions which may have passive gains, you can use the losses to offset gains. when the syndication is over, any remaining paper loss (negative balance) will then convert to active loss and can be used to offset active income (wages, etc). this paper loss comes to you on a k-1 (i forget which line).

[SeattleCPA]

So I think the key thing is, the assets you get bonus depreciation on will probably not create "unrecaptured section 1250 gain" but "section 1245 recapture."

The K-1 will describe precisely how you do the accounting.

But I'm now thinking that what's been misunderstood here (at the very least) is my thinking you're already taking this depreciation. I bet you're not taking it yet. Probably you haven't even seen your first K-1.

What that K-1 may show, btw, is a loss in box 1 maybe due solely to bonus depreciation appearing on the partnership tax return.

It might be, for example, $100K...

But you won't be able to take that loss. It'll get suspended because you're a passive investor. Probably for two reasons. One the investment is real estate which is usually automatically passive. The other reason because you lack material participation.

In the end, when the partnership disposes of the activity (the building they cost segregated) I bet all this stuff nets out. So if they sell at same price they paid on purchase next year, your last K-1 unlocks a $100K loss that's been suspended in year one... and then it recaptures $100K of section 1231 gain some of which is unrecaptured Section 1250 gain and some of which is Section 1245 recapture.

Bottomline: You maybe don't need to worry about "not" taking the depreciation because the passive loss limitation rules will make you delay taking it until you have income.

BTW if this is true, the cost segregation doesn't necessarily get you any value that I see. It means you lose 1250 gain and add 1245 recapture.