Possible Rental Gotcha for Retirees

[Cobra9777]

I hope you are correct, as I'm planning to sell a property in a few years and will have quite a gain and recapture, it would be nice if it costs less than I currently think.

Maybe they changed the rules since 2015 , but even this CPA website says the recapture is at 25% and the normal capital gain is at normal rates..

"However, not all gains benefit from the long term capital gain tax rates. Depreciation recapture is the portion of the gain attributable to the depreciation deductions previously allowed during the period the taxpayer owned the property. The deprecation recapture rate on this portion of the gain is 25%. The reasoning behind the depreciation recapture rules is since the taxpayer received the benefit of a depreciation deduction that offset ordinary income tax rates (a potential Federal tax savings of up to 39.6%), the government is not going to grant the most favorable capital gains rates on the portion of the gain relating to these prior depreciation deductions. The following examples illustrate the concept of depreciation recapture."

Tax Matters: Tax Implications of “Depreciation Recapture” When Selling Real Estate

I think many websites provide examples with a 25% rate because that's a common result for people with other substantial sources of taxable income and/or many years of depreciation to recapture. Perhaps these websites also have a better chance of attracting potential clients by portraying the worst-case scenario. In any case, other websites are more specific. Here's a quote from Investopedia:

Unrecaptured Section 1250 income is taxed at a 25% maximum capital-gains rate, or less in some cases.

And here's another that's even more specific:

Unrecaptured Section 1250 Gain is taxed at a maximum capital gain rate of 25% under the long-term capital gain tax rules (15% for taxpayers in the 15% and 10% tax brackets on ordinary income).

IRS Pub 544 clearly lists 25% as the "maximum" tax rate on unrecaptured Section 1250 gain. It does not discuss specific rates beyond that except by reference to the Schedule D instructions and tax worksheet. That worksheet will make even patient people like me want to jump off the nearest building. But if you work through a simple example (preferably with TurboTax or other software), you will see that, at lower income levels, the depreciation recapture (aka... unrecaptured Section 1250 gain) can in fact be taxed at 15%.

It's not really ordinary income; it's a special capital gain rate. But I think perhaps the idea is that the depreciation is "recaptured" at your ordinary income rate, up to a max of 25%. So it's still a benefit for high-income taxpayers who deducted the depreciation in the 28% bracket and above. Also, I don't think it would make sense to have a CG rate higher than one's tax bracket based on ordinary income.

The good news for early retirees is: if the recapture is not huge, and you can squeeze it in while other taxable income is very low (before SS, RMDs, pension, etc), you might be able to avoid the 25% rate. If TurboTax is to be believed, that's exactly what we're facing in 2017.

 

[ERD50]

I've often heard real estate investment promoted, along with the line "and you can take all this depreciation on your taxes, even as the value goes up!". But as I figured, this gets tallied up when you sell. So it is a tax deferment, not a tax reduction (as many seem to think - though maybe not the posters here).

I just think too many people thought it was a 'free lunch', it's not, and now it's not very flexible in these cases.

-ERD50

 

[Golden sunsets]

nwsteve; My experience with extraordinary income in one year, potentially bumping Medicare premiums substantially, is not exactly the same as yours but may be applicable. I experienced a year with a large capital gain, which resulted in higher taxes and a MAGI that bumped me up two levels into the painful IRMAA premium category that you referenced. But.... medicare premiums are based on your taxes from two tax years ago. So I experienced the high income year in tax year 2014. At the end of 2015 I received notice that my medicare premiums for DH and I would increase to that second level for tax year 2016, based on my 2014 MAGI. However my income for tax year 2016 was going to be substantially less, so I filed form SSA-44, IRMAA Life Changing Event. The info I provided resulted in SS reversing its premium for 2016 and I never had to pay the larger premium. If I had filed the form a little later and had already started paying the larger premiums, they would have reimbursed me for the months that I had paid the higher premium. The key in submitting the form is to highlight the life changing event in such a way that it does not appear as just a blip in your income. In my case, the capital gain was the result of selling a part of my business, which significantly reduced the number of hours I worked. In your case, perhaps the reason would be that your business income has been reduced because you sold part of your business(the income producing property is part of your business income - right?) and you have had a substantial reduction in the number of hours you work as a result. Filing the form was very simple and the response from SSA was processed within 6 weeks. The key is that you must wait until you receive your notice of the premium increase (usually in late October or November) before you file form SSA-44.

 

[nwsteve]

I've often heard real estate investment promoted, along with the line "and you can take all this depreciation on your taxes, even as the value goes up!". But as I figured, this gets tallied up when you sell. So it is a tax deferment, not a tax reduction (as many seem to think - though maybe not the posters here).

I just think too many people thought it was a 'free lunch', it's not, and now it's not very flexible in these cases.

-ERD50

+1 I have not really seen not much discussion at all about the "end game" impacts and challenges, especially on retirees. As you say, all the good stuff about sheltering income and little on the OMG's when decide to sell.

 

[harley]

I don't know, I've seen a fair amount of discussion on the pain of depreciation reclamation when selling a rental. Enough to know that it exists, anyway. If there's not that much discussion about it it's probably because there isn't a damn thing you can do about it, other than die. You are forced to take the depreciation whether you want to or not, and as far as I know there's no way out (except a 1031 exchange, which is just a delaying tactic) of paying the tax when you sell. There's no games you can play like being in a lower bracket or anything. So it's acknowledged, but not dwelt upon. IMO.