Does a Rental property have to be depreciated or can I choose not to depreciate my rental when filing my taxes? ??? Thank you.
You might as well because if you don’t you will have to recapture the depreciation that you could have taken.
REALWORLD is exactly right…you might as well take the deduction, 'cause the IRS will get their money anyway…
Keith
If your property is generating a positive cash flow, then your rental income is taxed at your ordinary income tax rate.
For many of us, with positive cash flow properties, the depreciation expense offsets the rental income so that we are left with a tax loss on paper. The depreciation expense does not cost you any money out of pocket, but does help shelter rental income from taxes.
Tell us why you would consider not taking a depreciation expense. Is it because you don’t know how? Is it because you feel you don’t need it? Is it because you have heard about depreciation recapture so you believe you avoid recapture if you don’t take the expense?
Tell us why you are asking the question. Maybe we can help you see this issue in a clearer light.
I am asking the question because I did not have a positive cash flow in 2005 and already have a deduction, also to avoid paying taxes on the depreciation amount when/if I sell. Thank you Dave for your advice.
I take it this is your first year of rental property ownership. Whenever I acquire a new rental property, I often do not have a full year of rental income to offset all my operating costs resulting in a negative cash flow for the year.
Maybe this happened to you too.
When you have a net operating loss for the year in your rental property activity, you are said to have a net passive loss. The IRS does allow you to use up to $25K in net passive losses to offset your other ordinary income on your 1040. By taking your depreciation expense, you make your net passive loss even larger which allows you to reduce the tax bill on your other ordinary income even more.
The net passive loss allowance against other ordinary income is capped at $25K provided your other income is $100K or less. The passive loss allowance is reduced by $1 for every $2 that your other ordinary income exceeds $100K. When you get to $150K in other income, the passive loss allowance is phased out completely.
When you have net passive losses you can not use, you are allowed to carry them forward to the next tax year. Eventually you get to use the suspended losses in a future year, or you can offset your taxable capital gain on the property when you sell it.
While the tax code does not actually require you to take the depreciation expense, the tax code DOES penalize you if you don’t. When you sell the property, the depreciation that you SHOULD have taken will still be recaptured just as it would be if you had taken the depreciation expense.
So, take the expense to shelter more of your other ordinary income from taxes this year. If you have net passive losses that exceed your passive loss allowance, then suspend the unused losses and carry them forward to the next tax year – put them in the “bank” for future use.
If you are planning to use tax preparation software to do your tax return, I suggest TurboTax Premier. The premier version has a more robust help module and a more comprehensive guided interview than the Basic or Deluxe versions of TurboTax.
Dave,
Yes it was my first year and my first rental as well. Thank you for your advice. You really clarified for me what I have to do in my situation.
Ernie
VERY nice explanation Dave.
Dave and Mark,
A couple quick questions that either of you can answer…
We’ve all heard of the “recapture” of the unsed depreciation, but how does it directly affect the seller of the property at the time of the sale?? Is it added into the profit from the sale of the property??
Second, when a person uses the home office deduction, they are eligible to take the depreciation on their home. When they take that, does it affect their sale of the residence like it does for the rental property?? Or does the 250K Single Taxpayer, 500K MFJ rule ususally negate any of the depreciation consequenses??
I know it’s a little complex question but I figured that you gentlemen would be able to answer…
Thanks,
Kevin
As a general rule, in most cases it is a good idea to take any deductions you can take as early as you can take them. Even if you will have to pay them back, you are still getting an interest-free loan from the government.
Most R.E. investors I know (myself included) could always use extra capital and when it’s not only interest free, but also from the taxman… what more can you ask for? ;D
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 depreciation expense 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 (depreciation that did not really occur), 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 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%.
another good explanation, Dave.
And to Kevin’s other question: yes, the same applies to your home if you take home office depreciation. But you are correct, that the gain exclusion on your residence will probably negate it.
but as Roots notes, it saves you a buck or two today.
M
Prior to the most recent changes to the tax code, for the portion of your home that you reserved as home office, you were able to take a business expense for the prorated portion of the mortgage interest, the utilites cost, homeowners insurance, and the property taxes that were allocated to the home office. You could even take a depreciation expense for your home office.
When you sold your home, you had to treat the home office portion of your home as the sale of property used in your business and recapture the depreciation. The portion of your sale price allocated to the rest of the home qualified for the capital gains exclusion.
I believe the recent tax code changes eliminated the requirement to allocate between business use property and primary residence, allowing you to apply the capital gains exclusion to all of the profit from the sale of your home. I am not clear whether you are relieved of any responsibility to recapture depreciation that was taken.
Change the scenario. Convert your primary residence to a rental property for a couple of years before you sell it. Provided you still meet the two year use and ownership rules, you still qualify for the capital gains exclusion on the sale of your primary residence. However, any allowed or allowable depreciation must still be recaptured.