Depreciation doesn't fit my situation - am I missing something?

General Real Estate Investing
1

Hello,

I am renting out a house that I payed cash for. I didn’t have a job the first year and part of the second year I rented the house, so it doesn’t seem fair that I will have to pay 25% Depreciation Recapture for something that I never got. I have a job now and I still don’t think I benefit from the situation since I’ll be in the rental income will be in the 15% tax bracket. I am thinking about buying some more rentals in the future, however, I can only see the Depreciation scheme helping the people in the higher tax brackets. Is there something I missing?

Stephen

2

If you file taxes on the rental income you can use the depresciation to offset the income. Did you have to pay taxes at all?

3

The tax code is a set of rules. “Fair” is not one of them. Immediately divorce yourself of the concept of “fair.” The rules are what they are, and you should learn them so you can use them to your best advantage.

If you are renting property, you should report the rental income on Sch E. Regardless of your tax bracket, you should take depreciation to offset all or part of that income. Even 15% tax is greater than 0 tax. Depreciation can even give you a tax loss that can be used to reduce other income streams, saving you more than 15%.

Further, if/when you decide to sell the property, depreciation is recaptured whether or not you actually “use” it in earlier years. Therefore, it is to your advantage to take all depreciation that is available to you to lower tax in earlier years to offset the additional tax you will incur when you sell.

If you have to pay recapture on something you “never got,” well… your problem is that you should “have gotten” it along the way by taking depreciation every year.

4

I rented the house in the middle of the first year and I wasn’t working, so I didn’t make enough to pay taxes. When I sell the place I will have to pay approximately $400 dollars for the depreciation recapture amount for that year.

5

I thought that my situation might be different since I don’t own a rental business. I still can’t the depreciation helping too much unless the rental income is in or above the 25% tax bracket. I can see it being especially useful for a single person. Also, I paid cash for property, so that might make a difference.

6

Do I decrease the depreciation basis on the rental each year by the last years depreciation amount? The reason I ask is that Table 1 in Pub 551 shows that depreciation reduces the basis.

I noticed some of the other depreciation percentages (Table A-5.) add up to 1, but I didn’t try the same thing with the 27.5 year rental property depreciation since there’s a lot of values to add up and its not too easy to copy an paste the table into Excel.

Stephen

7

Ok, I added one of the columns in Table A6 and it comes out to be 100%.

The decrease in basis must have to do with the depreciation recapture. Is that correct?

8

Investors have long known that depreciation on depreciable real estate is an economic fiction. Since property values usually increase over time, depreciation has often been called a “phantom” expense. Congress even recognized this fact and instituted changes to the US tax code that introduced what is known as “depreciation recapture.”

Suppose you buy $75,000 of depreciable real estate and depreciate it by $10,000 during your holding period. The property’s book value (cost minus depreciation taken) would then be $65,000.

Now by selling the property for anything more than $65,000, you demonstrate that your $10,000 of depreciation was a phantom expense. The property did not depreciate at all – it went up in value.

If you sell the property for between $65,000 and $75,000, the amount of the selling price that exceeds $65,000 is the amount of depreciation that DID NOT really occur. Depreciation that did not really occur is said to be “recaptured” at the time of the sale. You must pay tax on it to make up for the deductions you took (or should have taken) previously.

Consider the following examples. In each case, an investment property is purchased for $100,000 and depreciated by $20,000 during the holding period – reducing the book value to $80,000 at the time of sale.

Case 1: The property is sold for $120,000 or $20,000 more than the original cost. The taxable gain on this sale (sale price minus book value) is $40,000. The first $20,000 of this gain is unrecaptured depreciation, and the rest is a capital gain.

Case 2: The property is sold for $92,000. The sale proceeds exceed the book value of $80,000, but do not exceed the original cost of the property. In this case, the $12,000 of gain on the sale is unrecaptured depreciation and there is no capital gain. The reader should note that although the property was sold for less than its original cost, there is no loss for tax purposes because the property was sold for more than its book value.

Case 3: The property is sold for $76,000 which is $4,000 less than its book value at the time of the sale. There is no unrecaptured depreciation and no capital gain. Instead, there is a capital loss of $4,000.

9

@shall: if you collected rent, then you have a rental business.

follow along on Dave’s example.

Now change his example by one simple fact: you didn’t take depreciation in the years before you sold the property. You could have, but you didn’t.

Note that you will STILL pay tax on the same gain as in Dave’s example – because recapture is on “depreciation that should have been taken.” The ONLY difference is that you will not have taken a deduction, and therefore reduced your tax, in the prior years.

When you look at your TOTAL tax picture after sale, you will have paid more in tax by exactly the amount of tax on the prior years’ depreciation that you did not take.

@shall: if your tax rate is zero for EACH AND EVERY YEAR that you had the rental income, then you will simply break even. You’re right, there is no benefit for you to take depreciation THIS year. But since you don’t know how the depreciation recapture rules might change in the future, you should take depreciation even in years where your tax rate is zero. You never know if that will be a future benefit.

10

Yes that makes a difference. You have cash in the dirt, I would get that cash out. Put a loan on that house as soon as you can.

11

What you are missing is what happens to the depreciation. You use the depreciation to offset your rental income, potentially creating a tax loss on paper. Since you are in the 15% tax bracket, then all of your tax loss is deducted from your ordinary income using what is called a net passive loss allowance. You are allowed to deduct up to $25K in net passive losses against your ordinary income.

Any passive losses that you cannot deduct in a given year are carried forward to the next tax year when they are used to offset rental income. Passive losses that you cannot use next year are “suspended” and carried forward again, year after year, until they are used up or the property is sold.

When the property is sold, ALL of your accumulated suspended net passive losses that were carried forward from previous years are taken as a deduction against ordinary income without regard to the $25K limit on the net passive loss allowance.

If you have followed this process, I hope you see that the depreciation (in the form of suspended passive losses) are eventually used.

I agree with you that it is an inequity in the tax code that recaptured depreciation is taxed at 25% while the tax benefit from the depreciation taken may have been only 15%.