Rental Property - Depreciation Recapture and Passive Losses

[Anonymous]

Hello Community - I have a couple of questions about rental property taxes, which I hope you can help with:

1) Depreciation Recapture: what is included here besides depreciation i.e. will house improvements, car depreciation amortized refi costs be included, and is it all taxed as 25%?

2) Passive loss carryforwards: at house sale time, are those deducted at Marginal Earned Income Tax Rate? I am a bit confused as it will be a LT gain (i.e. 15% tax rate) when house is sold but at what rate the passive losses be deducted ("recognized")? Understood that all besides depreciation (as it will be taxed at 25% for depreciation recapture?) will be deducted at Margin Earned Income Tax Rate? 

Simple examples will be very helpful as well. I think the 2 topics above are generally misunderstood a lot.

[DianeW777]

Your questions are answered below.

1. Depreciation Recapture: This includes the depreciation on the main house, the capital improvements that were listed on depreciation as well.  Any remaining amortization of refinance costs will be deducted in the year of sale.  Gain is taxed at a maximum of 25% capital gains rate to the extent the gain is at least as much as the depreciation expensed on your returns. Any gain above the depreciation amounts will be taxed at the regular capital gains rates.
   • The car, if it remains in your possession, but no longer used for business will simply be marked as disposed of and 'Yes' it was converted to personal use.  If you sell (includes trade in) the car later the depreciation or depreciation portion of the standard mileage rate will be factored in at that time.
2. Any passive loss that has been carried forward for your rental will be deducted in the year of sale.  When the property is disposed of these losses are used.  Be sure your carryforward loss is in your tax return.  It will reduce your income from all sources in the year of sale, but entered as an expense on your Schedule E from the 8582, automatically in TurboTax.

The sale of rental  assets is a simple process but an example of how to allocate the selling price to all of your assets, including land and then entry procedures are shown below.

The selling price should be prorated for each asset then entered for each asset when you indicate they were sold or disposed of. You will not lose the remaining depreciation because you will use the remaining basis against the selling price to determine gain or loss. 

To figure out the selling price for each asset:

1. Take the current basis of each asset against the total combined basis of all of your assets to figure out the sales price for each one; OR 
2. Determine a fair market value for each asset against the total value of all assets to figure out the sale price for each one. 

Use the original cost of each asset listed on depreciation, add those together then divide each one by the combined total to find the percentage of the cost for each asset.  Use that percentage times the sales price and sales expenses to find the selling price/sales expenses for each asset. (Choices would also be fair market value on the date of the sale or adjusted basis on the date of the sale, which is cost less depreciation.)

Example:  Original Cost (of each asset on your depreciation schedule)

$10,000 Land                = 13.33% 

$50,000 House              = 66.67%

$15,000 Improvements  = 20%

$75,000 Total                 = 100%

Multiply each percentage times the sales price/sales expenses to arrive at each individual sales price/sales expense.

I hope this example provides clarification to enter your sale.  You need to dispose of the property by telling TurboTax how and when it was disposed of.  Follow the instructions below.

1. Click on Wages and Income
2. Scroll to Rental properties and royalties, click Edit/Add or Start/Revisit
3. Do you want to review your rental?, click Yes
4. Under Rent and Royalty Summary, click Edit
5. Click Update to the right of Assets/Depreciation.
6. Do you want to go directly to your asset summary?, click Yes and Continue
7. Click Edit to the right of each asset to be disposed of/sold
8. Go through several screens until you get to Tell Us More About This Rental Asset
9. Click on This item was sold…….   And continue to answer the questions

You might also review information here.

[Anonymous]

@DianeW777  - thank you.

- Does it mean that I do not need to pay back the amortized refi costs and remaining amortization of refinance costs will be deducted for the year of sale? What about closing costs (when I bought the house) - what is their treatment at the time of sale?

- What determines the actual tax rate for depreciation recapture - I see you say " Gain is taxed at a maximum of 25% capital gains"?

- Do I understand right "any passive loss" that will be deducted at time of house sale ALSO includes accumulateded deprecition (i.e. total amount of all carryforwards + last years's passive loss)? If yes - it will be deducted from ordinary income (not capital gain rate)? 

[DianeW777]

Yes, the refinancing costs should be amortized until the house is sold, in the year of sale you will deduct the remaining amount that has not yet been amortized.

Closing costs at the time of purchases of the house are added to the cost basis of the house and included as part of the house for depreciation.  All of this will determine and adjust your cost basis of the house. If you have not previously included this with your cost basis, this would be another item that could be added on amendments or Form 3115, as explained in your other post.  

Settlement fees and closing costs for buying the property become additions to your basis in the property and part of your depreciation deduction, including:

• Abstract fees
• Charges for installing utility services
• Legal fees
• Recording fees
• Surveys
• Transfer taxes
• Title insurance
• Any amounts the seller owes that you agree to pay (such as back taxes or interest, recording or mortgage fees, sales commissions and charges for improvements or repairs).  
•  

If your income is high enough that you would be in a tax bracket higher than 25%, then your gain to the extent of depreciation will not be taxed higher than 25%.  If your income is already at a lower tax rate, that gain will be taxed at a lower rate.

Yes, the passive loss carryforward will be deducted as ordinary income in full in the year of sale as ordinary income.  It will reduce your income dollar for dollar in the year of sale, first any rental income and then other income if applicable.  Your loss carryforward incorporates all expenses, including depreciation, that have exceeded the rental income in the past.

[Anonymous]

@DianeW777 - I ran a simulation in TT Desktop assuming I sold the rental house last year. I see that "Depreciation (or depletion) allowed or allowable" is added in Line 22 of Form 4797. What I am not clear - where and how this Line 22 is calculated at ordinary income tax rate (i.e. tax bracket rate)? I only see that it is just deducted from the cost basis (Line 21) to come up to Total Gain - Line 24 that goes to Line 32. Then it just goes as LT gain in Line 11 in Schedule D. The Question is: where is the 25% treatment of depreciation recapture here? Apologies if I confuse anything here. It looks as it is a LT loss? But yes, there is Line 19 in Schedule D where Depreciation Recapture is less Net ST losses. Is it where a special treatment of up to 25% tax rate is applied? A bit confused.

[Anonymous]

@DianeW777 - Thank you again. I ran a simulation in TT Desktop and assumed that I sold the rental property last year. First, I see the accumulated depreciation is removed from the cost basis on Form 4797 (Line 22). Then I see that it all gets (Sale minus Adjusted Cost Basis) to Line 24 (Total Gain). Then along with "Land" value gain - it all goes to Line 11 on Schedule D, which is LT gain. Here is where my confusion is as I do not see separate treatment for just depreciation recapture to be at up to 25% tax rate. However, I see Line 19 in Schedule D (depreciation recapture minus ST losses) - is it where it is taxed at up to 25% tax rate? A bit confused.

Also, I see that rental house sale triggers NIIT which is unfortunate...any advice?

Regarding closing costs when I bought the house: if I forgot to include them in the cost basis when I bought the house - do I really lose anything? Understood that I could have depreciated closing costs but in the end I would still have to pay tax savings back as part of depreciation recapture? I can still add closing costs to the cost basis when I sell the house to lower gain. Is that correct? 

What about house improvements - if I forgot to depreciate them - can I add them to cost basis at time of sale to lower gain? For refi costs not yet amortized - do I add them to the cost basis?

Thank you

[DianeW777]

Yes, the amount on Schedule D will take into account the 25% for amounts that came from the 4797. Any gains will be offset by losses on the Schedule D. There will be a worksheet that actually calculates the tax and the tax tables will not be used if there is an overall gain.

Capital improvements and purchase costs would be part of the cost basis of the house and eligible for depreciation.  You would be required to calculate the depreciation that would have been allowed.  This would be done by adding these assets to your rental activity, separately from the house, using the original date placed in service for rental and then calculating the selling price for those assets as well.  You can use the same example provided in the other post.

And yes, you will lose that depreciation expense because it will be recaptured unless you use Form 3115.  

• About Form 3115, Application for Change in Accounting

Net Investment Income Tax (NIIT) - The information below will describe how it works and can be compared to your income.

U.S. citizens and residents. 

Individuals who have for the tax year (a) MAGI that's over an applicable threshold amount, and (b) net investment income, must pay 3.8% of the smaller of (a) or (b) as their NIIT. The applicable threshold amount is based on your filing status. 

•Married Filing Jointly or Qualifying Surviving Spouse is $250,000. 

•Married Filing Separately is $125,000. 

 Single or Head of Household is $200,000.

@Anonymous 

[Anonymous]

@DianeW777—thank you. For the below, do I understand you right that if I missed including purchase closing or improvement costs, then there is no way to add them when I sell the house? I am not sure I understand. Also, improvement costs were done in year 5 after I bought the house (not at the time of the house purchase).

Capital improvements and purchase costs would be part of the cost basis of the house and eligible for depreciation.  You would be required to calculate the depreciation that would have been allowed.  This would be done by adding these assets to your rental activity, separately from the house, using the original date placed in service for rental and then calculating the selling price for those assets as well.  You can use the same example provided in the other post.

And yes, you will lose that depreciation expense because it will be recaptured unless you use Form 3115.  

• About Form 3115, Application for Change in Accounting

[DianeW777]

Yes, you are correct and you seem to understand the tax law.  You cannot just add them into the cost basis when you sell.  Improvements are a depreciable asset just like the original house. For this reason you should consider completing the Form 3115 to take advantage of the depreciation you haven't claimed in the past.  Even if you should have a passive loss carryover, you can use all of that in the year of sale. There is only benefit to you by taking advantage of this opportunity the IRS allows.

The improvements would be dated when they were placed in service so it would be a different date than when the house was placed in service. 

@Anonymous 

[Anonymous]

@DianeW777 - thank you again. I am a bit confused. This article from TT says I can just add improvement costs to cost basis when I sell the house and does not tell to depreciate it: 

https://turbotax.intuit.com/tax-tips/home-ownership/home-improvements-and-your-taxes/L6IwHGrx6?utm_s...

I would appreciate advice/clarity on how to deal with improvement costs.

Similar to purchase closing costs, it seems I can just add those to the cost basis when I sell the house. There is no need to depreciate if I forgot to add them in the beginning. 

[MarilynG1]

Improvements that you make to rental property after you stop renting it, prior to selling it, would be added to Sales Costs.

Improvements that you made to the property before you started renting it would be included in the original Cost Basis you used when you started renting it.

Improvements you made after you started renting the property would be added as Assets and Depreciated.  You can add those assets now, using their original cost and date placed in service. 

Then when you sell you will have an Undepreciated Balance on the property and on the Assets to report in the sale.

Here's detailed info on Reporting Sale of Rental Property and Improvements.

@Anonymous