By Jason Watson (Google+)
This is the third question and answer of a three-part series.
Part 1 – Do rental properties offer good tax sheltering?
Part 2 – How do passive loss limitations affect me?
Part 3 – Is depreciating my rental a good thing?
So, is depreciating my rental a good thing? Yes, but there are some issues.
As mentioned in a previous frequently asked question (see Do rental properties offer good tax sheltering?), a large chunk of your rental losses (and subsequent tax sheltering) can be due to depreciation. An asset has a useful life, and while there are exceptions such as Section 179 and Bonus Depreciation with computers, machinery, etc., the IRS requires an amortization schedule where only a portion of the rental property’s value is deducted each year. Generally speaking, a rental property is depreciated over 27.5 years, and only that portion attributed to the dwelling itself and not the land is depreciated.
However, depreciated must be recaptured when you sell the asset, and in this case the rental property. Your cost basis is essentially reduced by the amount of accumulated depreciation, increasing your subsequent gain on sale. Since you deducted depreciation as an expense every year during ownership, you cannot deduct the original cost from your sale price to reach your taxable gain on sale. This would be double-dipping.
Here’s some more backdrop-
Gains on recaptured depreciation is taxed at your ordinary tax rate up to 25%, while the remaining gains are taxed at your capital gains rate (either 0% or 15% depending on your tax bracket). Let’s look at an example- you buy a property for $100,000 and over time you had accumulated depreciation of $30,000. And let’s say you sell this property for $170,000. You had an overall gain of $100,000, which equals your original purchase price less your accumulated depreciation. Since your gain is greater than your accumulated depreciation, the recapture gain rule will apply.
As a result your gain is divided into two different gains- one is called recapture or Internal Revenue Code (IRC) Section 1250 gain. Since you reduced your ordinary income during ownership with depreciation, this portion of the gain is taxed as ordinary income up to a 25% marginal tax rate. The other gain is simply capital gains. So, you would be taxed at 25% (assume the max) on $30,000 and 15% on the remaining $70,000.
Here is a table summarizing these numbers-
| Purchase Price | 100,000 | |
| Accumulated Depreciation | 30,000 | |
| Adjusted Cost Basis | 70,000 | |
| Sale Price | 170,000 | |
| Recapture Gain | 30,000 | Taxed as ordinary income (up to 25%) |
| Capital Gain | 70,000 | Taxed as capital gain (0% or 15%) |
| Total Gain on Sale | 100,000 |
Exception: if you can demonstrate that a portion of the gain beyond the capital gain is attributed to an increased value of land, you can reduce the amount of recapture gain. Since you cannot depreciate land, this exception is born out of the same premise. And often times, location location location (i.e., land) is a large portion of a residential property’s appreciation. The other portion can be attributed to increased costs of building materials and labor.
So what does all this gibberish about depreciation, recapture rates, gains on sale, double-dipping, etc. have to do with tax sheltering? A lot, actually. And proper tax planning can mitigate some of your tax consequence and it relates to how your gain is taxed.
Well, if you envision your marginal tax rate decreasing later in life, depreciating an asset today might actually create a positive tax consequence since the tax due on your recapture gain will be lower with annual depreciation than if you never depreciated at all. In other words, decreasing your taxable income today while you are in a higher tax bracket is similar to the so-called tax advantages of a 401k. Make sense?
Furthermore, if you choose to not depreciate your rental, the IRS still forces you to recapture the gains as if you properly depreciated the asset. There is a sliver of an exception involving the allowed versus allowable rule, and the computation of recapture gain. There are some mental gymnastics behind this exception, and more discussion is required. Quite frankly, these situations are about as common as pink elephants, so forget we even mentioned it.
Our Advice: First, contact us to determine your situation. Second, take a long look at your retirement years- will you work? Do you have other investments and income which might catapult you into a higher tax bracket? Pinpointing your tax bracket during retirement is tough- things change, unforeseen events occur, etc. The best initial advice is to hedge your bets- just like diversifying your portfolio, you should diversify your income streams and your tax rate risk.
Generally speaking, taking the maximum allowable depreciation is going to be our advice to the majority of rental property owners. And there is yet another angle- please see If I move back into my rental, how does that work?