Irs Depreciation Rule
I was told on the phone by IRS that even though my accountant claimed depreciation not taken on a rental will not be subject to tax when sold, that "any allowable depreciation whether taken(written off)or not is subject to 25% tax upon sale of property. I ammended 2 years of returns and to get the additional tax savings. Is this correct and true? If so I am going to end up with nothing if I hold the thing. Help. It was base lined at 210k in 1996.(for depreciation) I need to move back in for 2 years to qualify for primary residence. Should I wait any longer to move back in? I will earn 90k this year at my job and the house price in 1985 was 85k.
The IRS gave you correct information. Congratulations on seeking a second opinion on your accountant's advice. Depreciation recapture was introduced into the tax code in 1986, so in 1996, your accountant should have been well aware of the ramifications of not claiming depreciation.
If you hold the thing, you don't "end up with nothing" -- you still have the property with its market value intact. If you hold the property as a rental long enough (28 years), you just end up with a fully depreciated property.
You might also ask the IRS to review your depreciation basis. You say you paid $85K for the property in 1985, but "base-lined" a depreciation basis of $210K in 1996. You will have to explain what you did to "base-line" the property as this is a term with which I am unfamiliar.
Generally, when you place a property in service as an investment rental, your basis for depreciation is your cost basis minus the value of the land. If you paid $85K in 1985, and did not add any capital improvements, your basis for depreciation in 1996 should be no higher than $85K.
If you actually took too much depreciation, when you sell the property the excess depreciation is taxed to you at your ordinary income tax rate, while the allowed depreciation is recaptured at a 25% tax rate.
Let's say you move back into the property for two years to establish it as your primary residence before you sell. Your profit from appreciation will then qualify for the capital gains exclusion, but, you will still have to pay the 25%depreciation recapture tax for your period of investment use.
DaveT,
WOW...that's WAY over my head Dave...
....all I know is that I am forced to depreciate all my houses whether I want to or NOT...
I DON'T...but I have to!
DAMN!!!
....as always,
GoodInvesting, Rocky
Thank you Dave for spending so much time on your reply. I need to re-check the value used for depreciation first before doing anything. Keep up the great help for it is you and others like you who make this site key.
Quote:....all I know is that I am forced to depreciate all my houses whether I want to or NOT...I DON'T...but I have to!Rocky,
Just to be perfectly clear, depreciation of your investment property is optional. You are not required to take the depreciation expense. The IRS recapture rules just penalize you if you don't take the depreciation to which you are entitled.
are you sure about the depreciation being optional? i think i read on another board that the recapture was mandatory even if you didnt take the depreciation.
You read correctly. Recapture is mandatory. The "allowed" depreciation is recaptured whether "taken or not".
The IRS does not require you to take an annual depreciation expense. If you don't take the depreciation expense that the IRS allows, recapture just penalizes you.
How does recapture interact with the passive activity loss rules? Suppose I will have an unallowed whether or not I depreciate a rental property (e.g., rental income is $20,000, mortgage interest, repairs, etc., are $25,000, depreciation is $10,000). When I sell the property, is the depreciation recaptured even though I never really benefitted from it?
tfolkman,
You never "lose" the benefit of a depreciation expense. In your example, you have a $15K passive tax loss (including depreciation). If you have no other passive gains to offset with this loss, then your $15K net passive loss can be used to offset your ordinary (active) income subject to caps on the amount of income and allowed passive loss.
If the passive loss can not be used to offset ordinary income, then it is suspended and carried forward to the next tax year. When you sell the property, suspended passive losses are added to your basis and act to reduce your taxable gain. Depreciation is only recaptured when the property is sold.
How can one make the "passive" losses become "active" ones? Specifically, if you participate significantly in the management of the rental property, doesn't this qualify as "active" income?
Also, what are the specific income limitations on passive losses. Isn't that eliminated completely if your active income is over something like $100k or $150k?
Thanks!
Kevin
Quote:How can one make the "passive" losses become "active" ones? Specifically, if you participate significantly in the management of the rental property, doesn't this qualify as "active" income?By default, the IRS treats a rental income activity as a passive activity regardless of your level of participation.
There is a difference between active participation and material participation. If you manage your rental properties, approve tenant applications, and collect rents for your own properties you are an active participant in a passive activity. Even if you use a professional property manager, but reserve for yourself the key decisions on rent increases and tenant applications, you are an active participant.
Now let's say that you are engaged full time as a real estate professional or in a related business -- such as professional property management. Now when you perform your services for others for a fee, you are materially participating in an active business. Material participation has some qualifying rules, such as 750 hours working at the business each year, and that time must be at least 50% of all the time spent in active (income producing) activities.
If you qualify as a real estate professional, you have the option of treating your passive losses as active losses, and offsetting (dollar for dollar) your active income with all of your "passive" losses without regard to income or passive loss caps.
There is a drawback. If you have treated your rental activities as active income, your profit on the sale of the property is treated as ordinary income (not capital gains).
Quote:Also, what are the specific income limitations on passive losses. Isn't that eliminated completely if your active income is over something like $100k or $150k?Yes there are caps. You may use up to $25K in NET passive losses to offset active income. This passive loss allowance is reduced by $2 for each $1 of ordinary income over $100K. However, the passive losses that you can't use don't go away and are not lost. They are suspended and carried forward to the next tax year.
DaveT,
Thanks for the knowledgeable reply!
So, is there any advantage to active participation in the management of the passive income investment (i.e., rental property)?
Also, is it true that the limit on passive losses is $25k/year unless you are a "real estate professional" (as you defined - 750 hours, etc.)?
Am I getting this right now? Seems like I'm just missing the significance of the "active participation" in management of the passive investement.
Thanks,
Kevin