Cap Gains and Depreciation Recapture ?s: selling our rental

[Villanelle]

We are getting ready to list our rental property for sale.  We haven't lived in it 14 years, so cap gains are coming to our 2024 tax bill.

Several questions.  We bought in 2004, lived in it until 2010, at which point we started renting it.  For the depreciation recapture, is it 27.5/ the basis (structure, not land) at the time we bought, or the time we started renting it out?  (yes, we've been claiming it on our taxes, but I'm not certain we've been doing it correctly, and I know that you repay the entire amount, whether you claimed it or not.  And actually, they basis was lower in 2010 than when we bought, thanks to the 08 crash.  We had our property taxes reassessed and dramatically lowered shortly before we moved out.)

Next, what improvements, if any, can be used to reduce either that depreciation or the cap gains?  I see that realtor fees come off, but what about new floors, a new fridge, redoing the bathroom, painting, or anything else we've done during the 14 years it's been a rental. yes, I've google but I've seen very mixed answers.

Do the cap gains tax rates work like regular tax brackets?  I see that if your income is over $517k (MFJ), the cap gains rate is 20%.  Our regular income is nowhere near that; does that include the proceeds from the sale, or is that including the sale proceeds?  And if it is the latter, is everything below $517k taxed at the 15%, and only everything over $517k (and is that regular income plus the sale proceeds, added together) taxed at 20%? 

Finally, we are looking at a HUGE tax bill from all this.  Like, $70k if I'm calculating correctly for both the depreciation and the cap gains.  Do I need to set up quarterly payments to avoid an underpayment penalty, or does that not apply to this situation?
 
(No, a 1031 exchange isn't in the cards.  And I am aware of tax loss harvesting and may do a little, but I'm wondering if there's anything relating specifically to the house we can use.) 

[bacchi]

When you change property you held for personal use to rental use (for example, you rent your former home), the basis for depreciation will be the lesser of the FMV or adjusted basis on the date of conversion.

The basis for LTCG is adjusted based on depreciation and improvements. There's an example on page 24 under "Figuring the basis" of the above publication.

Capital improvements are somewhat more of an art than a science though there are some examples listed in the IRS docs. See Table 1-1 on page 8 for a list. Capital improvements are added to the cost basis and also need to be depreciated on their own schedule.

LT capital gains are progressive. They stack on top of regular income.

[morethanconquerors]

The basis should be the lesser of cost or FMV when you began renting the property. FMV could be tricky to figure, so your cost could be a more solid number to use. You would take your purchase price + any closing costs and allocate a portion to land and a portion to the building. We usually use assessed values from the county auditor site to get a good estimate of how to split land vs building values. The building basis would then be depreciated over 27.5 years. Your adjusted basis today would be the total value assigned to the land + a little less than half of your original basis assigned to the building (14 years of depreciation of a 27.5 year asset). The depreciation taken on the building will be recaptured and taxed as ordinary income.

If you have expensed any of the improvements you mentioned, you cannot add them to your basis. If you have capitalized them on a prior return and  depreciated, then yes, they would add to your basis, with any prior depreciation getting recaptured on the sale.

Take regular income + depreciation recapture + capital gain less standard deduction and any other adjustments. This is your taxable income. Your CG rate is based on what bracket you fall in. Your CG will either be taxed at 15% or 20% depending on where you fall, while the remainder of your income, including depreciation recapture, will be taxed progressively based on whatever tax bracket you fall in.

Look at your prior year tax return. You will not be assessed penalty as long as you withhold or pay estimates equal to last year's liability.

[Villanelle]

The basis should be the lesser of cost or FMV when you began renting the property.FMV could be tricky to figure, so your cost could be a more solid number to use.You would take your purchase price + any closing costs and allocate a portion to land and a portion to the building. We usually use assessed values from the county auditor site to get a good estimate of how to split land vs building values. The building basis would then be depreciated over 27.5 years. Your adjusted basis today would be the total value assigned to the land + a little less than half of your original basis assigned to the building (14 years of depreciation of a 27.5 year asset). The depreciation taken on the building will be recaptured and taxed as ordinary income.

If you have expensed any of the improvements you mentioned, you cannot add them to your basis. If you have capitalized them on a prior return and  depreciated, then yes, they would add to your basis, with any prior depreciation getting recaptured on the sale.

Take regular income + depreciation recapture + capital gain less standard deduction and any other adjustments. This is your taxable income. Your CG rate is based on what bracket you fall in. Your CG will either be taxed at 15% or 20% depending on where you fall, while the remainder of your income, including depreciation recapture, will be taxed progressively based on whatever tax bracket you fall in.

Look at your prior year tax return. You will not be assessed penalty as long as you withhold or pay estimates equal to last year's liability.

Thank you for this!  We just increased our withholdings slightly so we should be withholding more than last year, so it seems our bases are covered for any penalty.

This is going to be a massive, massive tax bill--6 figures, I think--for the depreciation and the cap gains.  Of course, that means we will have made a lot on the sale and had that deprectiation helping us on previous tax bills.  But it's still going to sting to send that money off to Uncle Sam.

[MrGreen]

We are looking at a near identical situation and I have a follow-up question or two. I understand the cost basis and depreciation expense calculations well and have a solid handle on those numbers. What I'm not totally clear on is how improvements are added to basis. We finished the basement of our house, which included a bathroom, while we were living there. We converted the house to a rental later. My understanding is that improvement costs made during our occupancy are added to the total cost basis. Any improvements that have been made since the house was transitioned to a rental were taken in the tax year they were made as a rental expense.

From that perspective, the depreciation recapture tax is on the amount we depreciated (assuming we calculated it correctly), and LTCG tax would be on the remainder of any gain. Do I have that right?

Our example
$260,000 original purchase price
$25,000 of improvements while used as primary residence
$190,000 cost basis of structure used for depreciation calculation
= $6,909 depreciation per year while rented (190,000 / 27.5)
$34,545 total depreciation after 5 years

To calculate our adjusted cost basis, we take 260,000 original purchase price + 25,000 improvements - 34,545 depreciation = $250,455

Say the sale nets us 330,000 after real estate commissions and deductible closing costs. The gain is $330,000 - 250,455 = 79,545.

Of that gain, 34,545 is depreciation recapture and subject to that tax rate (ordinary up to 25%) and the remaining 45,000 will be taxed as long-term capital gain.

Do I have that right? I can't seem to find any examples online that include improvements made to a property that need to be added to cost basis. All of them show a purchase price, depreciation calculation, and depreciation recapture/capital gain calculation based on sale price but I'm not certain if I'm doing the math right on how improvements are added to the cost basis.

[GilesMM]

We are looking at a near identical situation and I have a follow-up question or two. I understand the cost basis and depreciation expense calculations well and have a solid handle on those numbers. What I'm not totally clear on is how improvements are added to basis. We finished the basement of our house, which included a bathroom, while we were living there. We converted the house to a rental later. My understanding is that improvement costs made during our occupancy are added to the total cost basis. Any improvements that have been made since the house was transitioned to a rental were taken in the tax year they were made as a rental expense.

...

Capital improvements (as opposed to repairs or maintenance) during rental are treated the same as capital improvements when you live there: they add to the basis for depreciation.   You should have a running tally each year with any improvements added to the basis and starting their way down the depreciation curve.  If there is an option to expense them entirely in one year, I'm not aware of it.

[MrGreen]

We are looking at a near identical situation and I have a follow-up question or two. I understand the cost basis and depreciation expense calculations well and have a solid handle on those numbers. What I'm not totally clear on is how improvements are added to basis. We finished the basement of our house, which included a bathroom, while we were living there. We converted the house to a rental later. My understanding is that improvement costs made during our occupancy are added to the total cost basis. Any improvements that have been made since the house was transitioned to a rental were taken in the tax year they were made as a rental expense.

...

Capital improvements (as opposed to repairs or maintenance) during rental are treated the same as capital improvements when you live there: they add to the basis for depreciation.   You should have a running tally each year with any improvements added to the basis and starting their way down the depreciation curve.  If there is an option to expense them entirely in one year, I'm not aware of it.

We've had minimal improvements since the house was converted to a rental. Mainly appliance replacement. In the early ears we set those up on a depreciation schedule but I recently learned that appliances under $2,500 can be taken as an expense in their entirety during the year of replacement so that's what we did last year knowing we were likely going to sell and be unable to take the full deduction of a five year depreciation schedule.

[Villanelle]

We are currently redoing the very dated and worn bathroom, as well as painting the kitchen cabinets, swapping out old lighting and a few other things.  Additionally, we are carpeting over damaged wood floors and taking out built-in bookcases to covert a library room back to a usable bedroom.  (It was in library-from when we bought it). Some new appliances, a new window, and a few other things.  All of this is after the last tenant moved out, before listing. 

I'm confused about what is maintenance/repairs, and what is an improvement.  I'm pretty sure appliances, painting walls, and replacing a window (with a smaller one, so also some exterior work) are all repairs.  But not sure about things like bathroom remodel or painting kitchen cabinets, or un-library-ing the bedroom. Of course, none of this will have been depreciated as it happens in the same year we will presumably close on the sale.  Is there an IRS doc that helps figure this out? 

[GilesMM]

We are currently redoing the very dated and worn bathroom, as well as painting the kitchen cabinets, swapping out old lighting and a few other things.  Additionally, we are carpeting over damaged wood floors and taking out built-in bookcases to covert a library room back to a usable bedroom.  (It was in library-from when we bought it). Some new appliances, a new window, and a few other things.  All of this is after the last tenant moved out, before listing. 

I'm confused about what is maintenance/repairs, and what is an improvement.  I'm pretty sure appliances, painting walls, and replacing a window (with a smaller one, so also some exterior work) are all repairs.  But not sure about things like bathroom remodel or painting kitchen cabinets, or un-library-ing the bedroom. Of course, none of this will have been depreciated as it happens in the same year we will presumably close on the sale.  Is there an IRS doc that helps figure this out?

https://www.irs.gov/pub/irs-pdf/p5712.pdf


Repairs and maintenance keep the property in it's current condition.  Improvements make it better.  Paint usually is maintenance, unless, for example, you are painting your new addition/extension.  A remodel depends on if it is a remodel to keep it about like it was or make it better.  This can be quite subjective so document it all in case of an audit. 

[Catbert]

Villanelle - I'm not sure of your age, but if you're on Medicare be aware that IRMMA  will give you higher Medicare premiums for one year based on your high income.  That year won't be the one in which you actually had the high income. You're probably younger so I won't go into more detail.