1) Can you take the excess depreciation and use it against ordinary income outside of the property?
Not directly. Your depreciation expense for your rental property is taken on Schedule E. When you have taken all your allowed rental expenses (to include depreciation) against your rental income, you either have a taxable passive income or a passive loss. If you have a loss, then your loss from that rental property is first used to offset passive rental income from other rental properties you may own… Then, if you still have a passive loss from rental operations, your loss is used to offset passive income from other (non-rental) passive activities. Next, any passive loss you still have is used to offset capital gains from rental property you sold.
Finally, after all this, if you still have a net passive loss, you can use your $25K net passive loss allowance to offset your other ordinary income. Any net passive loss you have left over, after taking your net passive loss allowance, is suspended and carried forward to the next tax year when the cycle is repeated.
2) When you decide to sell, can you still do a tax deferred exchange even though the property was initially your primary residence?
Yes you can in your scenario. Once you have used your former primary residence as a rental property for three years and a day, your property is automatically converted to an investment property. Investment property does qualify to participate in a 1031 exchange. Your Section 121 capital gains exclusion can be reinstated if you resume occupancy as your primary residence for another two years.
Even if you have Section 121 capital gains exclusion eligibility, your former primary residence – now converted to rental use – is eligible to participate in a 1031 exchange. While the Section 121 capital gains exlcusion is the more preferable tax treatment, there may be occasions when you would opt for Section 1031 tax treatment instead, provided the property is being used for a qualified investment purpose when the exchange is opened.
3) If you just sell and pocket the capital gain, how does depreciation recapture come into play?
Depreciation taken since May 1997, or the depreciation that you should have taken since May 1997, reduces your cost basis in the property. If you sell for more than your cost basis (or book value), then a certain amount of depreciation did not really occur. The depreciation that did not really occur is “recaptured” and taxed at a flat 25%.
4) Are you still taxed at the 25 % rate for the amount you depreciated even though you held the property for more than two years as a personal residence, thus avoiding capital gains taxes?
Yes, though in your example your property no longer qualifies for the capital gains exclusion because you had the property in rental service for 5 years.
As long as the property was used as a rental, then the allowed (or allowable) depreciation is recaptured even if you still qualify for the capital gains exclusion on your profit from appreciation. Note, that the depreciation you were allowed to take is still recaptured even if you did not claim any depreciation expense on your Schedule E.