Thursday, January 28, 2010

Don’t Claim Depreciation?? Part II: Tax Rates

My previous entry in this series explained that rental real estate property owners and taxpayers claiming the home office deduction have to pay tax on the depreciation that they could have deducted even if they didn’t claim it on their tax returns over the years. Ouch! Luckily, there is a provision in the tax law that allows you to catch up your depreciation deductions in the year you sell the property. What does it matter if you get a deduction in the year of sale for the same dollar amount as the extra gain it relates to? It can be of huge importance because the depreciation deduction first offsets your ordinary income, such as rental income, salary, interest, non-qualified dividends, self-employment earnings, and retirement/pension income that is taxed at your highest marginal ordinary tax rate, whereas the gain attributable to the depreciation is taxed at a maximum capital gains tax rate of 25%. That’s a great deal: the deduction offsets other ordinary income and the corresponding income is a capital gain. This is the core of the foolishness of not claiming depreciation to which you are entitled. A future installment in this series will discuss how the passive activity rules can delay the ordinary tax deduction.