Don’t Claim Depreciation?? Part V: Depreciation Recapture

This final installment in the series on whether to claim depreciation on a rental property or home office clarifies the term depreciation recapture. Since depreciation is an ordinary expense, without depreciation recapture a taxpayer could get an ordinary tax deduction in one year and then sell the asset in a later year and pay capital gains tax on the income that results from the basis reduction from depreciation. In addition to shifting income to a later year, this converts ordinary income into capital gain. This a great deal for the taxpayer. To prevent this, the depreciation recapture rules say that the portion of the gain that results from depreciation is taxed as ordinary income instead of capital gain. However, this is yet another area of the tax law where real estate investments really shine. Unlike other business assets, only the real property gain attributable to depreciation in excess of straight line depreciation is recaptured. Since real estate put into service after 1986 generally must be depreciated using the straight line method, there is typically no depreciation recapture on real property. However, there is unrecaptured Section 1250 gain, which is similar to depreciation recapture but uses a special “capital gains” tax rate not to exceed 25%. Since this is a capital gains rate, it is not technically depreciation recapture. While 25% is not as good as the capital gains rates for most assets, it sure beats paying tax at an ordinary rate of up to 35%.

© Michael Fitzsimmons, CPA, San Diego, CA http://fitz-cpa.com/

Don’t Claim Depreciation?? Part IV: Passive Activity Rules

Continuing the discussion of whether to claim depreciation on a rental property or home office… The passive activity rules can suspend the deduction for depreciation so that it is not immediately available to offset ordinary income from such items as salary, interest, non-qualified dividends, self-employment earnings, and retirement/pension. Since rental losses are passive, it will still offset other passive income, either from the same property, other properties, or a flow-through entity such as a partnership, limited liability company (LLC), S-corporation, estate, or trust. But any suspended deduction is carried forward until adjusted gross income drops below $150,000, or positive passive income is realized, or the property is sold. So even if the depreciation deduction is suspended under the passive activity rules, you are almost always no worse off than if you did not claim the depreciation, and will usually be much better off.

Don’t Claim Depreciation?? Part III: Time Value of Money

Previous installments of this series discussed depreciation concepts for rental real estate property owners and taxpayers claiming the home office deduction, including “allowed or allowable” and capital gain vs. ordinary tax rates. Another reason to claim the depreciation when allowed is the time value of money. If you claim a depreciation deduction now and offset your salary or other ordinary income, but you don’t pay tax on the related capital gain until you sell the property, maybe 10 years or more in the future, you effectively earn interest or an investment return on the amount of deferred tax during the interim. This is a basic wealth-building concept that should be employed whenever possible. To take it one step further, you may use a Section 1031 exchange to defer the capital gain indefinitely or use the ultimate tax strategy: die while still owning the property and get a step-up in basis for your heirs so that the tax gain just disappears.

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. http://fitz-cpa.com/real_estate.aspx

Don’t Claim Depreciation?? Part I: Allowed or Allowable

“Don’t take depreciation because you will have to have pay tax on it when you sell the property.” I have heard this from many real estate rental property owners and taxpayers claiming the home office deduction. What they don’t realize is that you have to pay tax on the depreciation you could have claimed even if you didn’t claim it. What? Yes! The tax law on this has been around for many years and is very well established. If you doubt it, just look at Line 22 of IRS Form 4797, “Sales of Business Property” (home office and rental real estate are Internal Revenue Code Section 1250 business property for this purpose). The cost basis of the property sold must be decreased (and therefore the gain increased) by the amount of depreciation allowed or allowable, whichever is higher. “Allowed” means what you claimed on your tax returns over the years. “Allowable” means what you could have claimed. Future discussion of this topic expands on this issue, discussing catching up missed depreciation, capital gains and ordinary tax rates, and the time value of money.

Real Estate Tax Assessment Appeals in San Diego, California

The California State Board of Equalization Letter to Assessors 2009/021, 04/29/2009, confirmed that San Diego County has certified the last day of the real estate tax assessment filing period. The regular appeals filing period for San Diego real estate tax assessments will begin on July 2, 2009 and will end on November 30, 2009.

California Real Estate Agent is a Qualifying Real Estate Professional

The IRS argued that a rental property owner who held a California real estate agent’s license, but not a California real estate broker’s license, was not engaged in the real estate brokerage trade or business. The IRS said that the agent was not a qualifying real estate professional entitled to the exception from the passive activity loss rules that generally apply to rental real estate losses, and disallowed the loss deductions on the agent’s tax returns. This is completely contrary to the way that this issue has been handled for many years by taxpayer, CPA’s, and the IRS. In the Tax Court case Agarwal, TC Summary Opinion 2009-29, the Tax Court summarily slapped down the IRS for this nonsense and determined that the taxpayer didn't even have to be licensed as a real estate agent, let alone a broker, to be treated as engaged in the real estate brokerage trade or business and eligible for the qualifying real estate professional exception to the passive activity loss rules on rental real estate.

Real Estate Section 1031 Exchange QI Conversion

Conversion of Qualified Subchapter S-corporation Subsidiaries (QSSS or QSub) serving as real estate tax-deferred Section 1031 exchange Qualified Intermediary (QI) to C-corporations will not cause the corporations to be treated as new or different Section 1031 QI’s. Therefore, S-Corporation subsidiary conversion to C-Corporation will not cause pending real estate tax Section 1031 exchanges to fail. (PLR 200908005).

Longer Net Operating Loss Carry-Backs for Business Tax

The new tax law, the American Recovery and Reinvestment Act of 2009, allows small businesses that incur Net Operating Losses (NOL’s) in 2008 and later years to carry the loss back 2, 3, 4, or 5 years. Previously only a 2-year carry-back was allowed. For businesses that paid taxes in any of these years but incurred a loss in 2008, this carry-back can result in an immediate tax refund. The new rules apply to all small business tax returns, including S-Corporation tax returns, C-Corporation tax returns, Limited Liability Company (LLC) tax returns, partnership tax returns, and sole proprietorship / Schedule C tax returns. The rules also apply to losses from rental real estate.

Rental Owners Under-Reporting Income

Government Accountability Office estimates that 50% of rental property owners either underreported revenues or overstated expenses, costing the government $13 billion in lost tax collections in 2001. Look for reminder letters from the IRS on this issue – their weak attempt to increase collections.

Late Election to Treat All Rental Properties as Single Activity for Material Participation / Loss Deductions

Married taxpayers who acted reasonably in good faith allowed by IRS in Private Letter Ruling to make a late election to treat all their interests in rental real estate as single rental real estate activity, allowing them to meet active participation requirement to deduct losses. – San Diego CPA Michael Fitzsimmons

Real Estate Section 1031 Exchange Escrow Earnings

IRS has ruled that earnings on section 1031 exchange escrow funds are not taxable if used for exchange fees on small exchanges (exchange proceeds are $2 million or less).