I have a few simple and straight forward questions regarding income taxes from rental income and captial gain taxes when a rental property is sold.
When we recapture depreciation (at the time of sale) that was deducted from passive income throughout the years the property was held, is that amount taxed at our normal income rate or is it taxed at the capital gains rate?
Am I missing something here or is it true that eventhough we have a positive cash flow in any given year from a rental property we can still claim a net loss for the year and pay no taxes that year on the passive income if the interest paid that year + the allowed depreciation deduction for that year was more than the net operating income?
Is it true that if we have a net loss in any given year that loss can be carried over to the next year and be deducted from the next years passive income? Is there a limit to how much we can claim as a net loss or how long we can carry it over to future years?
Finally, If I owned a rental property for 5 years and each year I netted a loss or 20,000 and the loss was carried over each year, by the end of the 5th year when I go to sell the property I would have acquired a total net loss of say 100,000 dollars. Can this amount be deducted from my taxable capital gain amount or can I deduct this amount from my taxable depreciation recapture amount? The reason I ask this question is because if depreciation recaputure is taxed at normal yearly income tax rate, which is higher than capital gains tax, I would want any carried over net loss at the time of sale to decrease the amount of depreciation I have to recapture. But if depreciation recapture is taxed at capital gain tax rate, it doesnt really matter, you would just adjust the basis and tax all gains at capital gains rate.
Thank you for you help, I tried to be clean, clear and concise in my question, but sometimes when you’re not sure you know what your talking about its hard to be clear. :-\
Depreciation is recaptured at a 25% rate, regardless of your income tax bracket.
2. Am I missing something here or is it true that eventhough we have a positive cash flow in any given year from a rental property we can still claim a net loss for the year and pay no taxes that year on the passive income if the interest paid that year + the allowed depreciation deduction for that year was more than the net operating income?
Yes, it is true. Mortgage interest paid and allowable depreciation both offset your taxable rental income, dollar for dollar. It is entirely possible to have a net passive tax loss for your rental property activity, yet have a positive cash flow from your rentals.
3. Is it true that if we have a net loss in any given year that loss can be carried over to the next year and be deducted from the next years passive income? Is there a limit to how much we can claim as a net loss or how long we can carry it over to future years?
If your rental property activity has a net passive loss for the year, you can (with limitations) use your net passive losses to offset up to $25K in other ordinary income. This passive loss allowance is phased out when your other income exceeds $100K and is reduced to zero when your other ordinary income reaches or exceeds $150K.
Passive losses and prior year suspended passive losses are used in the following order:
Against rental income,
Against passive income from other passive activities,
Against the capital gains from the sale of your rental property, and lastly,
Against other ordinary income subject to the $25K passive loss allowance.
Net passive losses that you can not use are suspended and carried forward to the next tax year. Any passive losses not used next year, are suspended and carried forward again. Suspended passive losses are carried forward each year until the property is sold or they are used up.
4. Finally, If I owned a rental property for 5 years and each year I netted a loss or 20,000 and the loss was carried over each year, by the end of the 5th year when I go to sell the property I would have acquired a total net loss of say 100,000 dollars. Can this amount be deducted from my taxable capital gain amount or can I deduct this amount from my taxable depreciation recapture amount?
The simple answer to your compound question is yes, however a complete answer is a little more complicated. First, let me describe
[b][u]How Depreciation is Recaptured[/u].[/b]
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 depreciation recapture, 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 considered a depreciation recapture 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 depreciation recapture and no capital gain. Instead, there is a capital loss of $4,000.
Currently, the depreciation recapture tax rate is 25%, while the maximum long-term capital gains tax rate is 15%.
Now when you sell your property, the $100K suspended passive loss (for that property) is added to the book value of the property you sold. Now go through the cases above and determine whether your sale fits Case 1, Case 2, or Case 3 and calculate your capital gain and depreciation recapture accordingly.
Thank you these answers were great. I have one more question along the same lines. When you sell your property can you add sale costs such as realtor commission to your book value to decrease your taxable gain?
Most of us use the Net Sale Proceeds to calculate profit. Net Sale Proceeds is the contract sale price reduced by the selling costs such as closing costs and real estate commissions.
It is the net sale proceeds amount that will appear on the 1099 given to you by the settlement attorney or title company. Subtract your book value from the net sale proceeds to determine your taxable profit.
If you, instead, choose to add the selling costs to your basis and use your contract sale price to compute the profit, the final result will be the same.