Depreciation Recapture - how does it work?

[Amethyst]

**All numbers are fictional**

Let's say we sell for $200K a property that we bought for $150K and have rented out for many years. During those years we took a total of $75K depreciation, along with $60K in "real"(as in actual business expenses) passive, unallowed losses.

The broker fee is $12K, closing costs (paid by us) are 5K.

Simple arithmetic to determine capital gain for tax purposes:

Orig cost $150K minus $75K depreciation = Cost basis of $75K
$200K - $75K = "Gain" of $125K
Subtract passive unallowed loss $60K and selling costs $17K = "Gain" of $48K. This is the amount on which we would owe tax.

Did I do the math correctly? Or is the depreciation part treated in a special way?

(Note: I did try to parse the relevant IRS pubs. My head still hurts).

Thank you,

Amethyst

[Souschef]

I sold a rental property a few years ago and had to recapture the depreciation.Your math is correct on that. The only thing I am not sure about is the unallowed passive loss.
I believe that if it is a real expense and you were not allowed to deduct it against the rental income, you can deduct it now. I would like to have a CPA or tax expert check me on that.

[pb4uski]

I'm not sure of how the $60k unallowed passive losses impact it either.

But let's put those aside and say you did have a gain of $108k ($200k sales proceeds - $17 selling costs - $75k adjusted cost basis)... $75k would be ordinary income because of depreciation recapture and the remaining $33k would be capital gain.

[gauss]

I spent some time digging into the passive loss rules a few months ago.

If I am not mistaken you can apply the $60k in unallowed passive losses to your basis when you sell -- as long as it is an arms length transaction.

If an estate or a trust owns the property, on the other hand, the passive losses die on the vine when the property is sold/transferred.

If you are a glutton for punishment, check out the IRS' own Passive Activity Loss Audit Technique Guide (ATG)

-gauss

[Huston55]

Can someone explain where the passive loss comes from?

How is it different than depreciation?

[kaneohe]

Quote:

Originally Posted by Huston55 Can someone explain where the passive loss comes from? How is it different than depreciation?

From Sch E, the income/expenses statement is shown below. The net income
is (Rents - "real biz expenses" ) - depreciation . "Real biz expenses" is the sum of all the expenses except depreciation. As an example, assume Rents=20K, "Real biz expenses" = 80K, and depreciation=75K. Then
(Rents - "real biz expenses" ) = -60K so net income = - 60K - 75K
The total passive loss is -135K of which depreciation is -75K and the remaining
- 60K is the passive loss considering income and all "real biz expenses" (but not
depreciation".

3 Rents received . . . . . . . . . . . . . 3
.................................
Expenses:
5 Advertising . . . . . . . . . . . . . . 5
6 Auto and travel (see instructions) . . . . . . . 6
7 Cleaning and maintenance . . . . . . . . . 7
8 Commissions. . . . . . . . . . . . . . 8
9 Insurance . . . . . . . . . . . . . . . 9
10 Legal and other professional fees . . . . . . . 10
11 Management fees . . . . . . . . . . . . 11
12 Mortgage interest paid to banks, etc. (see instructions) 12
13 Other interest. . . . . . . . . . . . . . 13
14 Repairs. . . . . . . . . . . . . . . . 14
15 Supplies . . . . . . . . . . . . . . . 15
16 Taxes . . . . . . . . . . . . . . . . 16
17 Utilities . . . . . . . . . . . . . . . . 17
18 Depreciation expense or depletion . . . . . . . 18
19 Other (list

[kaneohe]

slightly different interpretation of Amethyst's numbers

Orig cost $150K minus $75K depreciation = Cost basis of $75K
$200K - $75K = "Gain" of $125K
Subtract .................... selling costs $17K = "Gain" of $108K. This is the amount on which we would owe CG tax. Of this amount 75K is recaptured
depreciation (25% tax rate) and the balance of 33K is CG taxed at CG rates.

In addition to this the disallowed passive losses of 60K are now allowed on
Sch E leading to a loss on line 17 of the 1040.

Note that the net income of 75K recaptured depreciation and 33K CG and
-60K allowed passive losses = 48K is the same as Amethyst's example except distributed in different categories at different rates.......more favorably since the allowed passive loss offsets ordinary income rather than CG.

Depreciation recapture | Taxation for Real Estate investors - Michael Plaks

For the real answer, consider posting your question at fairmark.com in the capital gains forum.
************************************************** *********************
http://www.bankrate.com/finance/taxe...erty-sale.aspx

Dear Tax Talk,
What happens to "unallowed losses" on a Schedule E rental property? Due to a brief increase in income for two taxable years, I was unable to take ordinary income losses from a rental house. (The losses were reported on Form 8529.)

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The house was sold in June 2013 at a profit. Are the losses used to adjust my basis? Do I just forget about them and walk away?
-- Marion

Dear Marion,
Congratulations on the sale of your property. The good news is that the rental losses that were not deductible because of your higher income in prior years are going to be allowed on your 2013 income tax return since you have sold the property. Fortunately, with these types of losses you do not have to "forget about them and walk away."

To answer your first question: No, you do not use the losses to adjust your basis. Instead, you will calculate your deductible losses on Form 8582, which is used to calculate passive activity loss limitations. Please note: The Internal Revenue Service does not have a Form 8529 as you mentioned, and I am assuming that Form 8582 is the form that you used on your prior-year tax returns to calculate the amount of your deductible rental losses. In looking at the Form 8582 that is currently available from the IRS website, you will see that line 1c is where you enter your "prior year unallowed losses." Be sure to complete Worksheet 1 on Page 2 of Form 8582 because it is required.



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[Onward]

I just went through this with a knowledgeable Enrolled Agent.

Accumulated unallowed passive losses are added to your basis at the time of disposition of the property.

[Amethyst]

Thanks so much for the responses. Kaneohe, I think you answered my question with this bit:

"Note that the net income of 75K recaptured depreciation and 33K CG and
-60K allowed passive losses = 48K is the same as Amethyst's example except distributed in different categories at different rates.......more favorably since the allowed passive loss offsets ordinary income rather than CG."

Amethyst

[kaneohe]

Quote:

Originally Posted by Amethyst Thanks so much for the responses. Kaneohe, I think you answered my question with this bit: "Note that the net income of 75K recaptured depreciation and 33K CG and -60K allowed passive losses = 48K is the same as Amethyst's example except distributed in different categories at different rates.......more favorably since the allowed passive loss offsets ordinary income rather than CG." Amethyst

Please use with caution (verify, perhaps at fairmark.com ). Those are my words you are quoting......not some source w/ authority. A quote below
(bolded) says to report on the normal forms.......that suggests to me that capital gains should be kept separate from operating income (Sch E). They
are combined for the purpose of determining whether the activity had net gain
or loss but are reported separately, I believe........but that's my interpretation,
not the guaranteed truth.
************************************************** *
From p.8 of F8582 instructions:
Reporting an Entire Disposition
on Form 4797 or Form 8949
If you completely dispose of your entire
interest in a passive activity or a former
passive activity, you may have to report
net income or loss and prior year
unallowed losses from the activity. All
the net income and losses are reported
on the forms and schedules normally
used.

Combine all income and losses
(including any prior year unallowed
losses) from the activity for the tax year
to see if you have an overall gain or
loss.
If you have an overall gain, report the
income, losses, and prior year
unallowed losses on Worksheet 1, 2, or
3

[gauss]

Quote:

Originally Posted by kaneohe Please use with caution (verify, perhaps at fairmark.com ). Those are my words you are quoting......not some source w/ authority. A quote below (bolded) says to report on the normal forms.......that suggests to me that capital gains should be kept separate from operating income (Sch E). They are combined for the purpose of determining whether the activity had net gain or loss but are reported separately, I believe........but that's my interpretation, not the guaranteed truth. ************************************************** * From p.8 of F8582 instructions: Reporting an Entire Disposition on Form 4797 or Form 8949 If you completely dispose of your entire interest in a passive activity or a former passive activity, you may have to report net income or loss and prior year unallowed losses from the activity. All the net income and losses are reported on the forms and schedules normally used. Combine all income and losses (including any prior year unallowed losses) from the activity for the tax year to see if you have an overall gain or loss. If you have an overall gain, report the income, losses, and prior year unallowed losses on Worksheet 1, 2, or 3

+1

I was also a bit surprised to see this.

It is possible that it *might* be correct but I thought passive losses could only be used to offset passive income or be applied towards basis when selling to reduce any CG that may be due. Would need to research it myself to say anything with more certainty.

edit: It think I may have gotten this wrong. I struck out the above part that may have been incorrect.

[Cobra9777]

Quote:

Originally Posted by pb4uski I'm not sure of how the $60k unallowed passive losses impact it either. But let's put those aside and say you did have a gain of $108k ($200k sales proceeds - $17 selling costs - $75k adjusted cost basis)... $75k would be ordinary income because of depreciation recapture and the remaining $33k would be capital gain.

Ordinary income would be rare, as that would only apply to depreciation taken in excess of straight-line rates, which have been used on real estate since the 1980s. Straight-line depreciation is recaptured at a special, maximum capital gain rate of 25%.

I also have no idea about unallowed passive losses.

[kaneohe]

From https://www.irs.gov/businesses/small...5-dispositions
(note that this a chapter in Gauss's "glutton for punishment" reference above.

"The fact that an activity is passive does not determine the character of the gain (or loss) in terms of whether it is capital or ordinary in nature. Gain on disposition, usually capital in nature, will be reflected on Form 4797 and Schedule D. Current gains/losses as well as suspended losses represent ordinary income. They are generally entered on Schedule E and do not reduce capital gains reflected on Schedule D. "

[gauss]

Thanks for wading through the audit guide.

I am updating my incorrect post from above to include the corrections.

I also found Nolo's Every Landlord's Tax Deduction Guide book, which I borrowed from the library, to be quite useful with regards to these issues.

Quote:

Originally Posted by gauss I spent some time digging into the passive loss rules a few months ago. If I am not mistaken you can apply the $60k in unallowed passive losses to your basis to ordinary income when you sell -- as long as it is an arms length transaction. If an estate or a trust owns the property, on the other hand, the passive losses die on the vine can be applied to the basis when the property is sold/transferred. If you are a glutton for punishment, check out the IRS' own Passive Activity Loss Audit Technique Guide (ATG) -gauss

[Huston55]

Quote:

Originally Posted by kaneohe From Sch E, the income/expenses statement is shown below. The net income is (Rents - "real biz expenses" ) - depreciation . "Real biz expenses" is the sum of all the expenses except depreciation. As an example, assume Rents=20K, "Real biz expenses" = 80K, and depreciation=75K. Then (Rents - "real biz expenses" ) = -60K so net income = - 60K - 75K The total passive loss is -135K of which depreciation is -75K and the remaining - 60K is the passive loss considering income and all "real biz expenses" (but not depreciation". 3 Rents received . . . . . . . . . . . . . 3 ................................. Expenses: 5 Advertising . . . . . . . . . . . . . . 5 6 Auto and travel (see instructions) . . . . . . . 6 7 Cleaning and maintenance . . . . . . . . . 7 8 Commissions. . . . . . . . . . . . . . 8 9 Insurance . . . . . . . . . . . . . . . 9 10 Legal and other professional fees . . . . . . . 10 11 Management fees . . . . . . . . . . . . 11 12 Mortgage interest paid to banks, etc. (see instructions) 12 13 Other interest. . . . . . . . . . . . . . 13 14 Repairs. . . . . . . . . . . . . . . . 14 15 Supplies . . . . . . . . . . . . . . . 15 16 Taxes . . . . . . . . . . . . . . . . 16 17 Utilities . . . . . . . . . . . . . . . . 17 18 Depreciation expense or depletion . . . . . . . 18 19 Other (list

OK, I think I get the math from above (and in the subsequent posts), and interpret them as not being able to take credit for the 'passive' losses until disposing of the property.

But, who the heck landlords a rental that has $20k in annual income against $80k (or anything over $20k for that matter) in real annual expenses?

There must be something I'm missing here.

[kaneohe]

Quote:

Originally Posted by Huston55 ................ But, who the heck landlords a rental that has $20k in annual income against $80k (or anything over $20k for that matter) in real annual expenses? There must be something I'm missing here.

from the OP:

"**All numbers are fictional**"

[Huston55]

Quote:

Originally Posted by kaneohe from the OP: "**All numbers are fictional**"

Right, I got that. But, are there real world circumstances where such a passive loss would occur? Or, more importantly, would occur without the owner bleeding $$$, to later recoup said hemorrhaging upon sale (at a discounted value BTW).

[gauss]

Huston,

When my father passed away I inherited his condo as the sole beneficiary.
I didn't necessarily want to sell it right away and warmed up to the concept of a rental. As I dug into this, I found out that the condo association was considering amendments that would restrict renting. Thinking this would be quickly resolved one way or the other, I stood down not investing much money in to the condo until this was resolved. When the actual language of the amendment was revealed, it became clear that owners of record prior to approval would have their renting rights grandfathered.

All this took a long time to get finalized. Bottom line I had several years of expenses (ie disallowed passive losses) booked before I collected my first rent check.

This is one scenario where passive losses can appear. I suspect vacancies may be a frequent common thread in this area.

-gauss

[Amethyst]

Extended vacancies and unexpected issues can bleed anyone, and it can take a long time to sell in some markets.

Quote:

Originally Posted by Huston55 OK, I think I get the math from above (and in the subsequent posts), and interpret them as not being able to take credit for the 'passive' losses until disposing of the property. But, who the heck landlords a rental that has $20k in annual income against $80k (or anything over $20k for that matter) in real annual expenses? There must be something I'm missing here.

[Huston55]

Quote:

Originally Posted by gauss Huston, When my father passed away I inherited his condo as the sole beneficiary. I didn't necessarily want to sell it right away and warmed up to the concept of a rental. As I dug into this, I found out that the condo association was considering amendments that would restrict renting. Thinking this would be quickly resolved one way or the other, I stood down not investing much money in to the condo until this was resolved. When the actual language of the amendment was revealed, it became clear that owners of record prior to approval would have their renting rights grandfathered. All this took a long time to get finalized. Bottom line I had several years of expenses (ie disallowed passive losses) booked before I collected my first rent check. This is one scenario where passive losses can appear. I suspect vacancies may be a frequent common thread in this area. -gauss

Quote:

Originally Posted by Amethyst Extended vacancies and unexpected issues can bleed anyone, and it can take a long time to sell in some markets.

OK. Thank you both for the responses. Looks like either of these two situations or inability to take prior losses due to past high income could put someone in this situation. Appreciate the insight.