Depreciation Recapture

[BreathFree]

I don't know if this has been discussed but I just wanted to pass on to the forum that it appears depreciation recapture, with regards to selling a rental property, qualifies for the new 20% business tax deduction.

I simulated a sale in Turbotax. Turbotax states that the 20% will be applied to the depreciation recapture but not the capital gain portion of the proceeds from the sale.

Also, it did not matter that I selected I am not a real estate professional. All that matters is that the rental's purpose was for the pursuit of profit. Turbotax gives several examples which include vacation property rentals as well as multiplexes and single family homes.

 

[Sunset]

Well I hope that business deduction lasts for a bunch more years

 

[JDARNELL]

I don't know if this has been discussed but I just wanted to pass on to the forum that it appears depreciation recapture, with regards to selling a rental property, qualifies for the new 20% business tax deduction.

I simulated a sale in Turbotax. Turbotax states that the 20% will be applied to the depreciation recapture but not the capital gain portion of the proceeds from the sale.

Also, it did not matter that I selected I am not a real estate professional. All that matters is that the rental's purpose was for the pursuit of profit. Turbotax gives several examples which include vacation property rentals as well as multiplexes and single family homes.

I hope that is correct. Every little bit helps!

 

[clobber]

I'm not sure that "it appears" is good guidance. TurboTax can do different things depending on various situations. Please cite IRS documents.

Going against my own advice here, there are two non-authoritative, very recent links that contradict:
https://www.thebalance.com/depreciation-recapture-3192979
https://finance.zacks.com/unrecaptured-1250-gain-9659.html

 

[BreathFree]

I'm not sure that "it appears" is good guidance. TurboTax can do different things depending on various situations. Please cite IRS documents.

Going against my own advice here, there are two non-authoritative, very recent links that contradict:
https://www.thebalance.com/depreciation-recapture-3192979
https://finance.zacks.com/unrecaptured-1250-gain-9659.html

Neither of these articles address the new 20% business tax deduction, so I am not sure how they contradict what I said at all. Can you post the text that contradicts, as I do not see it in the articles you posted.


I agree everyone's situation is different. Here are two sources that state depreciation recapture is "qualified business income", the 2nd link has guidance form the IRS and goes into more detail, as stated your situation may differ from mine.


1st source - Turbo Tax Home and Business Software

"Ordinary gains (losses) from asset sales
Bear with us, this can be complicated. The Qualified Business Income (QBI) deduction is calculated using "ordinary" gains (losses) from the sales of assets used in a qualified business, but not capital gains. We've automatically calculated your ordinary gains/losses from all asset sales for this business. If all of your business assets were connected to a qualified business, then you don't need to enter anything here. Also, if none of the gains (losses) are connected to a qualified business, then you can just enter the total amount of gain (loss) that we've already calculated.

However...if some of the assets you sold are connected to a qualified business, and some are not, then things get...complicated. Sorry, we didn't make these rules. The following rules are used to determine when a gain (loss) is ordinary instead of capital. You'll need to determine the ordinary gain (loss) from any asset sales that aren't connected to qualified business income. Here are the rules for determining whether gain (loss) from an asset sale is ordinary.

For short-term asset sales, the entire gain/loss is ordinary.

For long-term asset sales, the rules are more complicated. Only the recaptured depreciation from any gains is treated as an ordinary gain. For real estate, this means only the additional post-1975 depreciation (times the applicable percentage) is ordinary to the extent there is gain from the sale. For all other asset types, this means any depreciation previously taken (including bonus depreciation and Section 179 depreciation) is ordinary gain to the extent the depreciation must be recaptured (i.e. the depreciation as ordinary gain is limited by the overall gain from the sale). None of the losses that result from these sales are considered ordinary losses."


2nd Source -
"Depreciation recapture that results in ordinary income (Sec. 1245 and Sec. 1250 recapture) is included in QBI when such income relates to a qualified business."



https://www.wipfli.com/insights/art...on-199a--the-20-percent-passthrough-deduction

 

[clobber]

Neither of these articles address the new 20% business tax deduction, so I am not sure how they contradict what I said at all. Can you post the text that contradicts, as I do not see it in the articles you posted.

Don't get me wrong, it would be great if what you are saying is correct. I also don't have a rental property any more, but have been following the recapture piece and trying to figure out the new rules. I'm not that well versed in QBI at the moment.

What I do know is that when I sold my last property, the depreciation recapture was calculated on line 38 of the Schedule D Tax worksheet. The latest version is located at the following link, and line 38 still shows multiplying by 25%. Again - I have not gone through it all so maybe the total depreciation amount is subtracted out somewhere else due to QBI.
https://www.irs.gov/pub/irs-prior/i1040sd--2018.pdf#page=16

In the previously linked articles, I agree they don't address QBI but they were written in 2019:

Zacks article: "Your capital gains tax is based on your regular tax bracket, while your unrecaptured Section 1250 gain is a flat rate. For 2018, long-term capital gains are taxed up to 15 percent for high earners, and the unrecaptured Section 1250 gain is now a flat 25 percent. So you’d pay 25 percent on $20,000 of the sale and up to 15 percent for the other $80,000, depending on your income."

Balance article: "Depreciation recapture can cause a significant tax impact if you sell a residential rental property. Part of the gain is taxed as a capital gain and might qualify for the maximum 20-percent rate on long-term gains, but the part that is related to depreciation is taxed at the higher tax rate of 25% "

 

[wolf]

My plan. Never sell rental real estate. Beneficiary gets step up in basis. Depreciation gone, no tax.

 

[BreathFree]

What I do know is that when I sold my last property, the depreciation recapture was calculated on line 38 of the Schedule D Tax worksheet. The latest version is located at the following link, and line 38 still shows multiplying by 25%. Again - I have not gone through it all so maybe the total depreciation amount is subtracted out somewhere else due to QBI.
https://www.irs.gov/pub/irs-prior/i1040sd--2018.pdf#page=16

"

I agree with all you posted - Schedule D, line 38, 25%. All is as I understand it.

The QBI deduction is not on Schedule D. QBI is on 1040 line 9. It is not a reduction in the recapture amount of 25%. QBI is a separate line item on the 1040 that allows the deduction of 20% of qualified income.

The IRS does have limitations and several types of income is listed that are not eligible but, recapture income is not listed.

Here: https://www.irs.gov/publications/p544 under section 1245 - A gain on the disposition of section 1245 property is treated as ordinary income to the extent of depreciation allowed or allowable on the property.

So IRS states that depreciation recapture is treated as ordinary income in this section and under QBI the IRS allows a 20% deduction of income.

I can not find where the IRS explicitly states that depreciation is eligible for QBI but TurboTax does state this, and several online CPA articles states this as well. So, I will wait for IRS to disallow it in writing before question the tax software.

 

[clobber]

Here: https://www.irs.gov/publications/p544 under section 1245 - A gain on the disposition of section 1245 property is treated as ordinary income to the extent of depreciation allowed or allowable on the property.

Now I'm getting WAY out of my comfort zone, but you quoted a rule about section 1245. Are we not talking about section 1250 property? When I sold my property it was under section 1250, but that may have been a different situation?

In the same IRS Pub 544 it says, "Unrecaptured section 1250 gain. Generally,
this is the part of any long-term capital gain on section 1250 property (real property) that is due to depreciation. Unrecaptured section 1250 gain cannot be more than the net section 1231 gain or include any gain otherwise treated as ordinary income. Use the worksheet in the Schedule D instructions to figure your unrecaptured section 1250 gain. For more information about section 1250 property and net section 1231 gain, see chapter 3."

A brief description of property sections:
https://ttlc.intuit.com/questions/2599636-how-do-i-know-if-business-property-is-section-1245-1250-1252-1254-or-1255


Our tax code is so messed up.

 

[FreqFlyer]

I agree, the tax code is so messed up and the TCJA didn't make it any simpler.

Before you classify the type of income (LT CG, ST CG, OI, Dep Recap) I believe you need to determine if the income is derived from a qualifying "business". Just being an active participant in the rental isn't sufficient.

Michael Kitces site did a good post on this topic recently.
https://www.kitces.com/blog/irs-notice-2019-07-199a-qbi-deduction-250-hours-safe-harbor-rental-real-estate-business/

To summarize: One can elect a safe harbor and take the QBI if the property is owned directly and the owner has 250+ documented rental services hours per year (performed by owner or agent/contractor of owner).

For one SF home rental it might be hard to justify and document such a large amount of hours to operate the business/property. I'm helping a friend in this situation and am wrestling the same question.

 

[BreathFree]

Now I'm getting WAY out of my comfort zone, but you quoted a rule about section 1245. Are we not talking about section 1250 property? When I sold my property it was under section 1250, but that may have been a different situation?

Our tax code is so messed up.

+1 Agreed!

Yes, my mistake. Section 1250 states the same concerning the recapture being labeled as ordinary income, which is the point I was making.

(A) In general If section 1250 property is disposed of after December 31, 1975, then the applicable percentage of the lower of—
(ii) the excess of the amount realized (in the case of a sale, exchange, or involuntary conversion), or the fair market value of such property (in the case of any other disposition), over the adjusted basis of such property, shall be treated as gain which is ordinary income. Such gain shall be recognized notwithstanding any other provision of this subtitle.

I understand what you are saying about recapture being taxed at 25%, I am not arguing that. I just wanted to recognize that the recapture is labeled ordinary income and maybe this is why it it included for computation of Qualified business income, 1040 line 9 in Turbotax. I say maybe because I am not privy to what IRS document Turbotax used to come to this conclusion.

Anyway, my intention of posting was to inform anyone interested that Turbotax is treating recapture as business income for the purpose of QBI deduction. That is a fact in my situation. I'm not a CPA, so take it for what it is worth and do your own research.

I can see it now. IRS asks, "What made you think you could deduct this on your taxes?" Filer, "Oh, some random, anonymous dude on the internet with less than 200 posts on a financial site told me I could." LOL!

 

[pb4uski]

I agree, the tax code is so messed up and the TCJA didn't make it any simpler.

Before you classify the type of income (LT CG, ST CG, OI, Dep Recap) I believe you need to determine if the income is derived from a qualifying "business". Just being an active participant in the rental isn't sufficient.

Michael Kitces site did a good post on this topic recently.
https://www.kitces.com/blog/irs-notice-2019-07-199a-qbi-deduction-250-hours-safe-harbor-rental-real-estate-business/

To summarize: One can elect a safe harbor and take the QBI if the property is owned directly and the owner has 250+ documented rental services hours per year (performed by owner or agent/contractor of owner).

For one SF home rental it might be hard to justify and document such a large amount of hours to operate the business/property. I'm helping a friend in this situation and am wrestling the same question.

Late to the party but I agree that the rub is that the IRS is unlikely to view a SF home rental as a qualifying business, so QBI would not apply IMO.

I looked at this hard for my Mom... she has a single tenant commercial building that is NOT a triple net lease... we pay the property taxes, water and maintainance and collect rent... probably 25 hours a year if that. It was tempting to give it a go even though we didn't fall under the safe harbor... if it was me I might have done it... but I didn't want to risk my 88yo mother getting into a hassle with the IRS.

 

[clobber]

@BreathFree

So - can you share some numbers? When I sold my property a few years ago (under the old rules), I recall that:

1) The depreciation recapture amount was entered on line 13 of the 1040. I did not have other "gains." Therefore it increased my Total Income on line 22 - and also my AGI on 37.
2) A horrible side effect was this actually put me into AMT. Ugh
3) After my taxable income was calculated, the depreciation recapture amount was backed out and taxed at 25%

I'm wondering how TT shows it working for you now? Do you have to add it in to Schedule 1 (so that it shows up on line 6 of the new 1040 maybe)? And then it also subtracts out on line 10?

 

[BreathFree]

@BreathFree

So - can you share some numbers?

Sorry, I would but it is too late. I only simulated a sale for 2018. I didn't actually sell any property in 2018, and I have already reset the return and filed for 2018. I was able to copy and paste one of the notices which I will include here. Funny to note that Turbotax themselves mention that this can be complicated and it is not on them.


The safe harbor mentioned above may not have been in effect in 2018 and that may be why Turbotax did not mention it. I will be interested to see if it comes up in 2019 as I did sell a property in March of 2019.


Here was all I was able to copy and paste from Turbotax. It doesn't answer any of our questions but at least you can see part of what I am referring to.



"Ordinary gains (losses) from asset sales
Bear with us, this can be complicated. The Qualified Business Income (QBI) deduction is calculated using "ordinary" gains (losses) from the sales of assets used in a qualified business, but not capital gains. We've automatically calculated your ordinary gains/losses from all asset sales for this business. If all of your business assets were connected to a qualified business, then you don't need to enter anything here. Also, if none of the gains (losses) are connected to a qualified business, then you can just enter the total amount of gain (loss) that we've already calculated.

However...if some of the assets you sold are connected to a qualified business, and some are not, then things get...complicated. Sorry, we didn't make these rules. The following rules are used to determine when a gain (loss) is ordinary instead of capital. You'll need to determine the ordinary gain (loss) from any asset sales that aren't connected to qualified business income. Here are the rules for determining whether gain (loss) from an asset sale is ordinary.

For short-term asset sales, the entire gain/loss is ordinary.

For long-term asset sales, the rules are more complicated. Only the recaptured depreciation from any gains is treated as an ordinary gain. For real estate, this means only the additional post-1975 depreciation (times the applicable percentage) is ordinary to the extent there is gain from the sale. For all other asset types, this means any depreciation previously taken (including bonus depreciation and Section 179 depreciation) is ordinary gain to the extent the depreciation must be recaptured (i.e. the depreciation as ordinary gain is limited by the overall gain from the sale). None of the losses that result from these sales are considered ordinary losses."

 

[gerntz]

Thanks BreathFree & those that commented. We have rental units.

Let me set up an example & see if I have this right:

So I bought rental property for $1M years ago that a) has appreciated to $1.5M, & b) has been depreciated to $0.5M. If I sell for the $1.5M, there is a) still LTCG taxes on $0.5M, but b) (25% Fed taxes on the depreciation x (100%-20%)) = $0.5M x 20% = $100K vs. $125K previously?

Thanks.

 

[pb4uski]

If you sell for $1.5m then your basis is $0.5m so you have a $1.0m gain.

$0.5m of the gain (equal to depreciation you were eligible to take, whether you took it or not) is a 1245 gain subject to 25% tax and the remaining $0.5m is LTCG subject to 15% tax (or more depending on income).

This thread relates to whether the 1245 gain is subject to a QBI deduction of 20%, which would reduce the 1245 gain from $0.5m to $0.4m.

 

[BreathFree]

If you sell for $1.5m then your basis is $0.5m so you have a $1.0m gain.

$0.5m of the gain (equal to depreciation you were eligible to take, whether you took it or not) is a 1245 gain subject to 25% tax and the remaining $0.5m is LTCG subject to 15% tax (or more depending on income).

This thread relates to whether the 1245 gain is subject to a QBI deduction of 20%, which would reduce the 1245 gain from $0.5m to $0.4m.

This is how I understand it. The 1245 gain was taxed first at the full 25%. Then, in a separate section the 1245 gain was considered QBI and added to any other QBI income you may have had from other properties or other businesses. There is a long worksheet of over 31 lines with various exclusions and limitations for each business and/or each rental propery. Then, an additional worksheet of 17 lines is applied to that total to compute the 20%, which is then added to line 9 on the 1040. I can paste the worksheet contents here if anyone wishes to view it. The worksheets do not address the original question of whether or not the 1245 gain is considered QBI. In 2018 Turbotax the info box stated as long as the rental was in pursuit of profit it was QBI, but there seems to be further guidance for 2019 that may disqualify some individuals based on personal time invested in the business activity.

 

[gauss]

Also, it did not matter that I selected I am not a real estate professional. All that matters is that the rental's purpose was for the pursuit of profit. Turbotax gives several examples which include vacation property rentals as well as multiplexes and single family homes.

.. Before you classify the type of income (LT CG, ST CG, OI, Dep Recap) I believe you need to determine if the income is derived from a qualifying "business". Just being an active participant in the rental isn't sufficient.

Michael Kitces site did a good post on this topic recently.
https://www.kitces.com/blog/irs-notice-2019-07-199a-qbi-deduction-250-hours-safe-harbor-rental-real-estate-business/

To summarize: One can elect a safe harbor and take the QBI if the property is owned directly and the owner has 250+ documented rental services hours per year (performed by owner or agent/contractor of owner).

For one SF home rental it might be hard to justify and document such a large amount of hours to operate the business/property. I'm helping a friend in this situation and am wrestling the same question.

I think the qualifying business criteria for QBI lies somewhere in between these two extremes. Congress never defined what a business is. IRS regulations and courts generally agree that the definition is two part:

#1) That your motivation is for profit
AND
#2) That you do it with regularity and continuity

This is in contrast to two other things that are similar to buisnesses but not treated as such by the IRS:
#a) Hobby Income
#b) Investment Income


The turbo tax portion quoted obviously ignores the 2nd requirement.

The 2nd quote mentions the safe-harbor that was recently created for the purpose of QBI and rental property. This is a sufficient but not a necessary condition for an activity to be considered a business.

You might want to look at the Nolo book on his "Every Landlord's Tax Deduction guide". It does a nice job of laying out when a rental activity would meet the business definition and provides citations.

If you are going to be in the landlord business for years to come, you might want to spend the extra time to understand this.

-gauss

 

[FreqFlyer]

The 2nd quote mentions the safe-harbor that was recently created for the purpose of QBI and rental property. This is a sufficient but not a necessary condition for an activity to be considered a business.

Agree completely.

I follow Ed Zollar's podcast on tax developments and he mentioned that the QBI may cut both ways.

In discussing whether triple net leases are qualifying businesses he writes:

I certainly think we have a very strong case this is a trade or business and, in fact, if it somehow showed a loss I think the IRS would have a strong case to force the members to recognize negative QBI (this can cut both ways, something often lost in the rental discussions I’ve seen to date)​

I guess what he's saying here is that if a rental produced a loss then 199A (QBI) could reduce the loss. Makes me head hurt a bit thinking about it.

 

[michelek]

This is not an accurate post.

 

[gerntz]

If you sell for $1.5m then your basis is $0.5m so you have a $1.0m gain.

$0.5m of the gain (equal to depreciation you were eligible to take, whether you took it or not) is a 1245 gain subject to 25% tax and the remaining $0.5m is LTCG subject to 15% tax (or more depending on income).

This thread relates to whether the 1245 gain is subject to a QBI deduction of 20%, which would reduce the 1245 gain from $0.5m to $0.4m.

And a tax of $100K on the $0.4M, right? If so, I think I got to the same place in a different manner.

If you sell the property, don't you have the 1245 gain whether you decide to take it or not? How would you not take it?

 

[pb4uski]

On the second part, what I was trying to say is that you have a 1250 gain (25% rate) even if you didn't claim depreciation in past tax returns while you rented the property.... so if you could have taken depreciation but for whatever reason didn't then you still have a 1250 gain that is subject to the higher rate.

 

[Cobra9777]

Capital gains are specifically excluded from QBI. Unrecaptured section 1250 gain on sale of real estate (often informally referred to as "depreciation recapture") is a capital gain and thus would not qualify. It's taxed at a special maximum capital gain rate of 25%.

OTOH, section 1250 gains due to "additional depreciation" in excess of straight-line (true depreciation recapture), would be taxed as ordinary income and would thus qualify for QBI. I think this is somewhat rare as SL depreciation has been in effect for a long time.

In addition, section 1245 recapture is taxed as ordinary income and would qualify for the QBI deduction. So this would cover any furniture or equipment that was part of the sale of a rental property... probably pretty small by comparison to the real estate itself.

Any form of "recapture" on short-term sales (rental property held less than 1 year) would also be taxed as ordinary income and would thus qualify for QBI. Again, pretty rare. Plus there would not be much depreciation or gain in such a case.

I just ran a test case in TurboTax Premier for a single taxpayer with only some interest income and the sale of a rental property held for 10 years. I told TT it was a qualified business. The gain on sale was taxed entirely at capital gain rates. This was a combination of unrecaptured section 1250 gain (to the extent of accumulated straight-line depreciation) plus regular CGs for the remainder of the gain. The only QBI deduction allowed was for 20% of ordinary rental income generated in 2018.

 

[pb4uski]

If you sell for $1.5m then your basis is $0.5m so you have a $1.0m gain.

$0.5m of the gain (equal to depreciation you were eligible to take, whether you took it or not) is a 1245 gain subject to 25% tax and the remaining $0.5m is LTCG subject to 15% tax (or more depending on income).

This thread relates to whether the 1245 gain is subject to a QBI deduction of 20%, which would reduce the 1245 gain from $0.5m to $0.4m.

In each case replace 1245 with 1250.

 

[Bongleur]

What I do know is that when I sold my last property, the depreciation recapture was calculated on line 38 of the Schedule D Tax worksheet. The latest version is located at the following link, and line 38 still shows multiplying by 25%. Again - I have not gone through it all so maybe the total depreciation amount is subtracted out somewhere else due to QBI.
https://www.irs.gov/pub/irs-prior/i1040sd--2018.pdf#page=16

In the previously linked articles, I agree they don't address QBI but they were written in 2019:

Zacks article: Your capital gains tax is based on your regular tax bracket, while your unrecaptured Section 1250 gain is a flat rate. For 2018, long-term capital gains are taxed up to 15 percent for high earners, and the unrecaptured Section 1250 gain is now a flat 25 percent. So you’d pay 25 percent on $20,000 of the sale and up to 15 percent for the other $80,000, depending on your income.

Balance article: Depreciation recapture can cause a significant tax impact if you sell a residential rental property. Part of the gain is taxed as a capital gain and might qualify for the maximum 20-percent rate on long-term gains, but the part that is related to depreciation is taxed at the higher tax rate of 25%

So this rate of 25% is a unique category, not related to the more familiar 0%, 15, 20% brackets? Is this a new thing? The Kiplinger's article on how to do depreciation recapture doesn't mention this:

https://www.kiplinger.com/article/i...on-tax-break-has-real-estate-consequence.html

Compare your realized gain with your depreciation expense... The lower of the two figures is the amount the IRS considers subject to depreciation recapture at your ordinary income tax rate. In this case, $10,000 is subject to depreciation recapture at your ordinary income rate. The remaining $5,000 is taxed at the capital gains rate.
***
EDIT - hold on, these two articles contradict each other:
Zacks article: your unrecaptured Section 1250 gain is a flat rate. ... and the unrecaptured Section 1250 gain is now a flat 25 percent.
vs
Balance article: the part that is related to depreciation is taxed at the higher tax rate of 25%