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May '07

REAL ESTATE INVESTORS BEWARE:

THE DEPRECIATION RECAPTURE TAX TRAP PART 1

In this edition of the Real Estate Revolution, we will provide our readers with an understanding of depreciation.

You cannot exclude from taxation any gains, which are attributed to the depreciation you claimed after May 6, 1997. I'll explain what that means in a minute.

You have owned the rental property for 11 years (which means you bought the property in 1995), and you rented out the property starting in 1997 (after living there for two years), it is likely that all or most of your depreciation will be recaptured.

Here's what recapture means. It means you have to pay tax on the gains that are attributed to depreciation. And these gains are taxed at your ordinary income tax rates, not at the much lower long-term capital gains tax rates. This is explained in IRS Publication 523, Selling Your Home, in the section entitled Business Use or Rental of Home (link to IRS Web site).

Let's provide an example with numbers to illustrate how depreciation recapture works in real life. I'm going to be making these numbers up. Your actual tax situation will be different. Let's say you bought the home for $120,000. And you started renting out the house on July 1, 1997. (This is conveniently located after the May 6, 1997, cutoff date. I'm trying not to have a math headache today.) You would have claimed $2,000 in depreciation in 1997, $4,363 in 1998, and $4,363 every full year after that that your property was rented out. So let's say the property was last rented in December 2005. This would give you eight full years of depreciation, and one partial year of depreciation, for a total of $36,904. This total depreciation is what accountants call "accumulated depreciation."

Accumulated depreciation reduces your cost basis in the property. So your initial cost of $120,000 gets reduced by this accumulated depreciation of $36,904, leaving you with an "adjusted cost basis" of $83,096. There may be other adjustments to your cost basis as well, such as capital improvements (roof, foundation, etc.).

Now, let's say the house will be worth $250,000 when it is sold, and you plan to sell the house after meeting the two-out-of-five year rule. The selling price minus the adjusted cost basis will equal the gain or loss. In this case, $250,000 minus $83,096 equals a gain of $166,904. Here's where the fun begins. Of this gain, the first $83,096 is taxed at ordinary income tax rates as depreciation recapture. (These are called "ordinary gains.") The remainder is considered capital gains. The capital gain portion in our example is $166,904 total gain minus $83,096 ordinary gain equals $83,808 capital gain. Only capital gain portion can be excluded under Section 121, up to the limits I mentioned above. As long as you live there a total of 24 months out of the 60 months preceding the sale of the house, these capital gains can be excluded.

Now, I hear a tiny voice somewhere saying, "Ah, well what if I didn't claim any depreciation? Then I won't have to recapture the depreciation." This wily tax strategy is already anticipated in the tax law. You must recapture depreciation you actually claimed or could have claimed for renting out the house.

The bottom line, in this example, is that your total gain is partially excluded and partially taxed. You will report the sale on IRS Form 4797 (Sale of Business Property).

Because of the complexity of your tax situation, now would be a good time to make friends with a tax professional. You will need to gather documents to accurately calculate your adjusted cost basis. Very likely, your tax professional will provide additional tips of what documents to gather.

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