The Hidden Dragon of Imputed Depreciation
I bought a house in July 1988 for $137,500 and rented it out for ten years. I took deductions for depreciation in tax years 1988 through 1995, but I forgot to take depreciation deductions in 1996 through 1998. My total depreciation deductions for years 1988 through 1995, as reported on my tax returns, were $37,496. My accountant has told me that if I had taken the depreciation deductions for 1996 through 1998, those deductions would have been approximately $15,000.
On January 1, 1999, I moved into the house as my primary residence and have been living in it since January 1999. While I have been living in the house, I have not rented out any portion of it, nor have I used any portion of the house for business purposes. I now have a contract to sell the house. After deducting my selling expenses from the sales price, I will net $335,000. I know that I will have a gain on the house, but I don’t know how much the gain will be or whether the gain will be taxable. I had heard that since I have lived in the house as my primary residence for the last two years, I might be able to exclude up to $250,000 of the gain from my gross income.
It is not an uncommon practice for a taxpayer who owns residential rental property to fail to take deductions for depreciation on his or her tax federal income tax returns. Usually, the taxpayer fails to take the deduction either because the taxpayer does realize that he or she is entitled to a deduction for depreciation, or because the taxpayer decides to “be nice” and not claim the additional deduction. Obviously, claiming a deduction for depreciation expense creates a tax benefit to the taxpayer in the year the deduction is taken. However, the depreciation deduction also reduces the taxpayer’s basis in the property for purposes of determining gain or loss at the time the taxpayer sells the property.
Usually, the motivation for the taxpayer who purposely decides not to take the deduction for depreciation is that the taxpayer does not want to reduce his or her basis in the property. However, what many taxpayers don’t realize is that even if the taxpayer does not take the deduction for the depreciation, when the time comes to sell the property, the depreciation that the taxpayer could have (or should have) otherwise taken will be imputed for purposes of determining gain on the sale of the property. Furthermore, instead of being taxed at favorable capital gains rates, the gain associated with the reduction in basis due to the imputed depreciation will be taxed at either ordinary income tax rates or at the 25% tax rate for unrecaptured § 1250 gain. Thus, many landlords are suddenly confronted with the fact that even if they don’t take the “sweet” of the depreciation expense while they own the rental property, they suffer the “bitter” of recapturing the imputed depreciation at the time of sale.
Net Proceeds Less Adjusted Basis
A taxpayer who sells a house, whether it is the taxpayer’s primary residence, a vacation home, or residential rental property, will realize a gain on the sale if the net sales proceeds to the taxpayer are greater than the taxpayer’s adjusted basis in the property. The net sales proceeds will generally be the sales price less expenses actually incurred and paid by the taxpayer as part of selling the house, such as broker’s commissions, closing costs, and certain expenses for fixing the house up to sell it. Generally, the taxpayer’s basis in the house will be the original price that the taxpayer paid for the house, plus the cost of any major improvements that the taxpayer made to the house, such as an addition or major structural remodeling.
If the house was the taxpayer’s primary residence, the gain on the sale of the house will be the difference between the net sales proceeds and the taxpayer’s basis in the house. However, if the taxpayer rented the house out or used all or a portion of the house for business purposes, the taxpayer may have taken, or may have been entitled to take, deductions for depreciation on the taxpayer’s current and prior years’ federal income tax returns. If the taxpayer took, or was entitled to take, such depreciation deductions, then the basis of the house must be adjusted by the total amount of depreciation deductions that the taxpayer actually took and/or was entitled to take on his or her tax return.
The irony of the rules regarding reduction of basis for depreciation taken is that, even if the taxpayer doesn’t actually take the depreciation deductions on the taxpayer’s income tax returns, the basis of the property must still be reduced by the amount of the depreciation that was allowable to the taxpayer under the straight-line method of depreciation. Thus, in our situation above, if the taxpayer held the house as residential rental property during 1996 through 1998, but failed to take a depreciation deduction on the tax returns for those taxable years, the taxpayer’s basis in the house will still have to be reduced by the $15,000 of depreciation that the taxpayer could have taken.
In our situation above, the original purchase price of the house was $137,500, and the taxpayer took and/or was entitled to take a total of $52,496 in depreciation deductions on the taxpayer’s current and/or prior years’ federal income tax returns. Therefore, the taxpayer’s adjusted basis in the house would be $85,004. If the taxpayer had sold the house in December 1998 for $200,000, the taxpayer would have a total gain of $200,000 minus $85,004, or $114,996. Of the $114,996 gain, $62,5000 would have been capital gain, and the remaining $52,496 would have been a combination of Section 1250 depreciation recapture and unrecaptured Section 1250 gain. Unrecaptured Section 1250 gain is discussed further below.
Exclusion of Gain on Sale of Primary Residence
Under Section 121 of the Internal Revenue Code, if, on the date of the sale of a house, the taxpayer has owned and used the house as the taxpayer’s primary residence for periods aggregating 2 years or more within the five-year period preceding the sale of the house, a certain portion of the gain on the sale of the residence will be excluded from taxpayer’s gross income. Generally, the amount of gain excluded is lesser of the amount of gain realized or $250,000. Thus, if the gain on the sale of the house is $175,000, the taxpayer will be able to exclude the entire $175,000. If the gain on the sale of the house is $300,000, the taxpayer will be able to exclude $250,000, but will have to report the remaining $50,000 of gain as a capital gain. If a husband and wife file a joint return for the taxable year of the sale of the house, and if they meet other requirements, they may be able to exclude up to $500,000 of gain on of their joint tax return.
Section 121 does not require the taxpayer to have used the house as the taxpayer’s primary residence during the entire time that the taxpayer owned the house. A taxpayer who converts the house from use as residential rental property to use as the taxpayer’s primary residence may still qualify for gain exclusion under Section 121 so long as the taxpayer owned and used the house as the taxpayer’s primary residence for at least two years within the five years preceding the sale of the house. A taxpayer who uses the house as a primary residence, then converts the house to residential rental property may still be able to utilize the gain exclusion under Section 121 so long as the taxpayer owned and used the taxpayer’s primary residence for at least two years within the five years preceding the sale of the house. However, if the taxpayer has only used a portion of the house as the taxpayer’s principal residence, the taxpayer will only be able to exclude that portion of the gain which is attributable to the portion of the house used by the taxpayer as the taxpayer’s principal residence.
In our situation above, the taxpayer converted the house from use as residential rental property to use as the taxpayer’s primary residence. However, because the taxpayer owned and used the house is the taxpayer’s primary residence for an aggregate of at least two years within the five years preceding the taxpayer’s sale of the house, the taxpayer’s use of the house still satisfies the “2 in 5” rule of Section 121. As a result, and subject to the unrecaptured section 1250 gain rule discussed below, the gain on the taxpayer’s sale of his house will qualify for exclusion under Section 121.
Unrecaptured Section 1250 Gain
When a taxpayer sells a house that has been used as both a primary residence and either as residential rental property or for business purposes, the Section 121 exclusion will not apply to any portion of the gain which is attributable to allowable depreciation for taxable periods after May 6, 1997. To the extent that all or any portion of the house was used for residential rental or business purposes, allowable depreciation is the total amount of depreciation that the taxpayer either actually deducted on his current and prior years’ tax return, and/or the amount of straight-line depreciation the taxpayer could have deducted, but failed to do so. The taxpayer must compute what the total amount of allowable depreciation is for any rental or business use of the house from May 6, 1997 until the date of sale. To the extent that the post-May 6, 1997 allowable depreciation does not exceed the total gain on the sale of the house, the post-May 6, 1997 depreciation will be treated as unrecaptured Section 1250 gain and will be subject to a maximum tax rate of 25%.
In our situation above, our taxpayer used the home as residential rental property until December 31, 1998. Thus, our taxpayer will have to determine the amount of allowable depreciation on the house for the period from May 7, 1997 through December 31, 1998. Based upon the original purchase price of $137,500 and using the straight-line method of depreciation over a 27.5 year life, that depreciation would have been $8,274.
At this point, we are now be able to determine what the taxpayer’s taxable position with regard to the sale of his house. The taxpayer’s original basis in the house was the purchase price of $137,500. The original basis is adjusted for the depreciation actually deducted and/or allowed due to the taxpayer’s use of the house as residential rental property. The total amount of the depreciation actually taken by the taxpayer from 1988 through 1995 ($37,496), plus the additional depreciation that was allowable from 1996 through 1998 ($15,000) is $52,496. Thus, the taxpayer’s adjusted basis in the house is the difference between $137,500 and $52,496, or a net amount of $85,004.
Subtracting the adjusted basis of $85,004 from the net sales proceeds of $335,000, the taxpayer has a realized gain of $249,996. Included in the realized gain of $249,996 the taxpayer has $8,274 of unrecaptured section 1250 gain that will not qualify for exclusion from gross income under Section 121. Thus, the amount of the taxpayer’s gain on the sale of his house that will be excluded from gross income will be $249,996 minus $8,274, or a net amount of $241,722. The $8,274 of unrecaptured section 1250 gain will then be subject to a maximum tax rate of 25%.