How to Calculate Depreciation on Rental Property When Selling

Selling a rental property involves more than just finding a buyer; it requires understanding the tax implications, especially concerning depreciation. Recapturing depreciation can significantly impact your capital gains tax. Here’s a breakdown of how to calculate depreciation on rental property when selling:

The core calculation involves two primary steps: First, determine the accumulated depreciation taken over the property’s lifespan. This is the sum of all depreciation deductions you’ve claimed. Second, understand how this accumulated depreciation impacts your taxable gain when you sell. You will generally have to pay a depreciation recapture tax on the accumulated depreciation up to the amount of gain realized.

Understanding Depreciation for Rental Properties

Depreciation, in the context of rental property, is the deduction you take each year to account for the wear and tear of the property and its components. It’s a non-cash expense that reduces your taxable income while you own the property. However, when you sell, the IRS “recaptures” some of these past deductions.

Determining the Depreciable Basis

The starting point is determining the depreciable basis of your rental property. This is typically the original purchase price, including closing costs, but excluding the value of the land. Remember, land is not depreciable. You may also need to account for significant improvements made during your ownership, adding these to the basis.

Depreciation Methods: Straight-Line is King

For residential rental property, the straight-line depreciation method is generally used. This means you depreciate the property equally over a set number of years, known as the recovery period. For residential rental property, the recovery period is 27.5 years.

To calculate the annual depreciation expense, divide the depreciable basis by 27.5. For example, if your depreciable basis is $200,000, your annual depreciation expense would be approximately $7,273.

Calculating Accumulated Depreciation

This is the total amount of depreciation you’ve claimed over the years you owned the property. It’s simply the annual depreciation expense multiplied by the number of years you’ve owned the property. Keep meticulous records of your tax returns; this is where this data is found. For instance, if you owned the $200,000 property for 10 years, your accumulated depreciation would be $72,730.

The Sale and Depreciation Recapture

When you sell your rental property, the IRS will want its share of the tax benefits you’ve enjoyed through depreciation. This is called depreciation recapture.

Calculating the Gain on Sale

First, determine your gain on sale. This is the selling price minus your adjusted basis. Your adjusted basis is your original basis (purchase price plus improvements) minus the accumulated depreciation.

For example:

• Selling Price: $350,000
• Original Basis: $200,000
• Improvements: $20,000
• Adjusted Basis: $220,000 – $72,730 (Accumulated Depreciation) = $147,270
• Gain on Sale: $350,000 – $147,270 = $202,730

Understanding Depreciation Recapture Tax

The depreciation recapture is taxed at your ordinary income tax rate, up to a maximum of 25%. This is applied to the lesser of the accumulated depreciation or the gain on the sale.

In our example, the accumulated depreciation is $72,730, and the gain on sale is $202,730. Therefore, $72,730 will be taxed at your ordinary income tax rate (up to 25%), and the remaining $130,000 of the capital gain ($202,730 – $72,730) would be taxed at the applicable capital gains rate.

Important Considerations

• Record Keeping: Accurate records of your purchase price, improvements, and depreciation deductions are crucial.
• Professional Advice: Consult with a qualified tax advisor or accountant to ensure you’re correctly calculating depreciation and understanding your tax obligations.
• Form 4797: Depreciation recapture is reported on Form 4797, Sales of Business Property.

Frequently Asked Questions (FAQs)

1. What if I didn’t claim depreciation every year?

Even if you didn’t claim depreciation on your tax return in previous years, the IRS still considers the amount of depreciation you should have claimed. This is called allowable depreciation. You’ll still be subject to depreciation recapture on this allowable amount when you sell. It’s essential to amend your tax returns if you missed claiming depreciation to accurately reflect your financial situation and avoid potential penalties.

2. Can I avoid depreciation recapture taxes?

There are a few strategies to defer or potentially avoid depreciation recapture taxes, including:

• 1031 Exchange: This allows you to defer capital gains and depreciation recapture taxes by exchanging your rental property for a “like-kind” property.
• Converting the Property to Your Primary Residence: If you live in the property for two out of the five years preceding the sale, you may be able to exclude a portion of the capital gains from your income under the primary residence exclusion rules. However, depreciation recapture would still generally apply to the period it was a rental.
• Giving the Property as a Gift: Gifting the property to someone else transfers the tax burden to them when they eventually sell.

Always consult with a tax professional to determine the best strategy for your specific situation.

3. How do I calculate depreciation on improvements?

Improvements to your rental property are treated separately from the original property. The cost of improvements is added to the depreciable basis and depreciated over the appropriate recovery period (often 27.5 years, but potentially shorter for certain components). Keep detailed records of each improvement and the date it was placed in service.

4. What happens if I sell the property for less than I paid for it?

Even if you sell the property for less than your original purchase price, you may still be subject to depreciation recapture tax if you have a gain on the sale after considering your adjusted basis.

5. What is the difference between cost segregation and depreciation?

Cost segregation is a tax planning strategy that involves identifying and classifying property components that can be depreciated over a shorter recovery period (e.g., 5, 7, or 15 years instead of 27.5 years). This can accelerate depreciation deductions and increase cash flow. Depreciation is the actual deduction taken each year based on the assigned recovery period.

6. How does depreciation affect my capital gains tax?

Depreciation reduces your adjusted basis, which increases your capital gain when you sell. This higher capital gain is then subject to capital gains tax, in addition to the depreciation recapture tax.

7. What is the unrecaptured Section 1250 gain?

The unrecaptured Section 1250 gain refers to the portion of the gain attributable to depreciation that is taxed at a maximum rate of 25%. This applies to real property.

8. Where do I report depreciation recapture on my tax return?

You report depreciation recapture on Form 4797, Sales of Business Property. This form calculates the gain or loss from the sale of business assets, including rental property, and determines the amount of depreciation recapture.

9. What are the best ways to keep track of depreciation deductions?

Maintain detailed records of:

• The original purchase price and closing costs.
• Any improvements made to the property, including the cost and date placed in service.
• Annual depreciation deductions claimed on your tax returns.
• Any adjustments to the basis, such as casualty losses.

Using accounting software or consulting with a tax professional can help you stay organized.

10. Does depreciation recapture apply to inherited property?

If you inherit rental property, you receive a stepped-up basis, which is generally the fair market value of the property on the date of the decedent’s death. Depreciation recapture does not apply to the deceased’s estate but will apply to any depreciation you take if you continue to use the property as a rental.

11. Can I depreciate personal property used in a rental property?

Yes, you can depreciate personal property used in a rental property, such as appliances, furniture, and carpeting. These items are typically depreciated over a shorter recovery period than the building itself.

12. How do I handle depreciation if I convert my rental property to personal use?

When you convert a rental property to personal use, you stop taking depreciation deductions. However, the depreciation you claimed while it was a rental property still impacts your basis, and depreciation recapture will still apply if you later sell the property for a gain.

Understanding depreciation and its implications when selling a rental property is crucial for minimizing your tax liability. Always seek professional advice to navigate the complexities of tax law and ensure you’re making informed financial decisions.