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Sale of Rental


Christian
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A client has placed a rental house she owns on the market. Concerned the sale would fall under the recapture rules I checked the date the house was set up for depreciation and see it was in 1998. After reading the rules earlier today it looks to me that it will not. Assuming it is sold this year I expect I will use it's depreciated basis which will surely produce a hefty capital gain and since I have not needed to handle one of these in years want to check to see if my assumption is correct.

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Below is from the Taxbook. To calculate the total gain on the sale you will use the adjusted basis that includes capital improvements and depreciation. However, it still appears that any of that gain that is attributable to straight line depreciation is taxed at 25% or depreciation recapture with the remaining gain taxed at 20% or maybe ordinary income. You might or may have already looked at Pub 544. The two bolded statements below seem to contradict themselves. I didn't find any information regarding rules on depreciation recapture pointing toward in-service dates. Could you share that please?

 

Section 1250 Property(Real property**)Ordinary Income. All depreciation is recaptured as ordinary income, limited to gain on sale.

Ordinary Income MACRS. Accelerated depreciation in excess of straight-line is recaptured as ordinary income. Applies to property on which bonus depreciation was claimed.

ACRS. All depreciation is recaptured as ordinary income for property depreciated under accelerated methods.  Certain exceptions apply. For disposition of property placed in service before 1987, see IRS Pub 544, Sales and Other Dispositions of Assets.

Capital Gain Any gain remaining after subtracting depreciation recapture is subject to regular capital gain maximum rate of 20%

Capital Gain1)25% maximum tax rate. Gain attributable to straight-line depreciation is capital gain sub-ject to a special 25% maximum rate Referred to as “unrecaptured section 1250 gain”2)20% maximum tax rate. Gain remaining after subtracting the 25% rate gain is capital gain subject to the regular capital gain maximum rate of 20%

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This statement is also from that TaxBook and I found this in an IRS Pub as well but can't remember the number. This statement also coincides with the first statement in my other post.

Depreciation Recapture—Special Depreciation Allowance When a taxpayer disposes of property for which he or she claimed a special depreciation allowance, any gain on the disposition is recaptured as ordinary income up to the amount of the special depreciation allowance previously allowed or allowable.

There is no recapture for residential rental and nonresidential real property unless that property is qualified property for which a "special depreciation" allowance was claimed.

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Sorry guys I got it from the 2017 edition of the U S Master Tax Guide sent to me by CCH. On page 1785 it reads in the second paragraph the following "Residential rental property and nonresidential real property that is placed in service after 1986 and is subject to MACRS must be depreciated under the straight-line MACRS method. Thus, there is no recapture of depreciation upon disposition of such property because no depreciation in excess of straight-line depreciation could have been taken." As noted in my submission this house was set up in 1998 well after 1986. In checking my setup for it it reads SL/GDS for 27.5 years.

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Basis minus depreciation equals adjusted basis.

Sales proceeds minus adjusted basis equals gain.

Gain minus accumulated depreciation equals Capital Gain which flows to Schedule D

The accumulated depreciation reported on the 4797 flows  to Form 1040.

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1 hour ago, Abby Normal said:

Where it's taxed at ordinary income rates,

I  think you meant to say where it is taxed at capital gain rates.

1250 gains are a hybrid; ordinary gains taxed at capital gain rates with a max rate of 25%.

The special tax treatment comes from the strong lobby arm of  the real estate industry.

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Dan is exactly right.  Only depreciation claimed in excess of straight line would be subject to recapture.  Since this taxpayer always claimed SL, no recapture.  The depreciation claimed does reduce basis, however, increasing cap gains.  The Sect 1250 recapture would only apply if the client has prior or future year losses, which won't be deductible to the extent of the unrecaptured gain resulting from depreciation.

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No, 1250 gains have a 25% max tax rate, which means for people in brackets less than 25%, the gains are taxed at their ordinary income rates, not capital gains rates of 0%, 15% or 20%.

I think we're getting mired in the wording and missing the practical.

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1 hour ago, Abby Normal said:

the gains are taxed at their ordinary income rates, not capital gains rates of 0%, 15% or 20%.

I think we're getting mired in the wording and missing the practical.

Unrecaptured 1250 gains are included in the computation of adjusted  net capital gains per sec 1(h)(3)(A)(1).

Therefore they are reported on schedule D (flows from 4797) and the related Capital Gains TAX worksheet.

From a practical and planning standpoint they are capital gains and offset capital losses.

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To answer Christian so that he may make sense of how this should be reported:

Christian, because your client used MACRS SL deprec, you are correct that there is no recapture of excess depreciation like happens with sec 1245 tangible property. That would be where that portion of gain is split out and the recapture portion is taxed at ordinary rates. That is NOT what is happening in your case.

What is happening - when real property is sold (sec 1250 property) that has been depreciated, that portion has the potential to be what is called "unrecaptured sec 1250 gain"  and that portion of the gain equal to the depreciation taken is carved out and can be taxed at a special rate up to a maximum of 25%, and that rate depends on the taxpayer's tax bracket.  Obviously with that carve out, it may be possible that the unrecaptured portion exceeds the total gain, but basically, carve it out and split the gain into its components that are taxed at different rates.  As cap gains, both of these portions of gain are able to be offset by cap losses, again obviously within the cap gain/loss rules and mechanics of Sch D.

Here is an example that may help:

  • Real property purchased $150K, accum deprec $30K, adjusted basis $120K
  • Sold for $185K, generates an overall gain of $65K
  • Unrecaptured 1250 gain is $30K (the amount of depreciation) and is subject to the higher cap gain rate with max of 25%, and the remaining gain of $35K would use regular cap gain rate. 
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You really have to love a tax forum where even the best educated flop over into arcane disagreements. LOL This one reminds me of a question I submitted years back and got some 35 or so contradicting replies ! I feel some comfort in the knowledge that I am far from being alone in my understanding of our tax code. In this client's case she being in the 10% bracket she may totally avoid any tax at all. This sale is reported on Form 4797 right with any result carried to the Schedule D ? This instead of using the Form 8949. 

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On 4/21/2022 at 11:38 AM, Christian said:

reported on Form 4797 right with any result carried to the Schedule D ?

Since it is a capital gain, the unrecaptured amount is combined with all the 1231 gains on form 4797 and carried over to schedule D in one lump sum.   However, when it comes to the capital gains tax computation; the 1250 gain is segregated to determine any amount that might be taxed at the 25 rate. 

It is especially important to understand the unique tax aspects of section 1250 in the planning stages.

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Does the ATX program sort out the 1250 gain ? If the 1250 gain is taxed at ordinary rates she is in the 10% bracket which is even lower than the 15% capital gain rate. I've got plenty of time on this so I will need to review it thoroughly. The house is not in good condition and sits on ten acres which will need to be segregated out. The land will likely compose most of the sale.

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On 4/23/2022 at 12:11 PM, Christian said:

she is in the 10% bracket which is even lower than the 15% capital gain rate.

If that is the case she is in the zero percent capital gains tax bracket.

 

On 4/23/2022 at 12:11 PM, Christian said:

If the 1250 gain is taxed at ordinary

It is not taxed at ordinary rates.

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