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Regular Contributor
Bowman
Posts: 67
Registered: ‎01-08-2013
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Selling rental property in 5 years

I am a bit confused about the tax laws that apply to selling a rental property.

 

Here is my scenario:

 

bought house A in 2001, lived in A till Oct 2010 as primary residence.

 

Then bought another house B, and rented out A in Oct. 2010.

 

 B is primary residence now, and A is rental.

 

I understand that the clock is ticking if I want to exclude any capital gains from selling A.  Specifically, if I sell A before Oct. 2013, then the 5 year use test shows that I lived in it for at least 2 years in the last 5 years, AND that there is no portion of the last 5 that is non-qualified use (basically, I understand non-qualified use to be portions after 2009 that you didn't have it as main home IF you used it again as a main home after a period of rental.  Any period AFTER your last use as a main home is excluded from non-qualified use as far I can tell, meaning that entire rental period is excluded from non-qualified use).  So the upshot is that if I sell before Oct 2013, I can exclude all of the capital gains (below 500k for married filing joint) from taxation modulo some deal with depreciation that I need to figure out.  

 

But what happens if you sell AFTER this 5 year period?  Say I sell next year by Oct.  Then I would have stayed only 1 out 5 years in the previous 5 years from the sale.  But still 9 out of 13 years total.  Do they prorate the gains for taxation somehow?  Or is it a on/off thing where the entire gain becomes taxable?  I am just trying to determine what the tradeoff is in paying capital gains taxes by holding on past the 5 year period versus any belief that you will get a higher sale price later (I mean to determine how much more the sale would have to generate to offset the taxes)

 

Thanks,

Bowman

Super Contributor
Curmudgeon
Posts: 265
Registered: ‎06-14-2012
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Re: Selling rental property in 5 years

My understanding is the exclusion is a yes-no matter; no proration applies.  

Gold Super Contributor
Jil
Posts: 3,135
Registered: ‎10-24-2011
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Re: Selling rental property in 5 years

I am not tax expert, but this is my understanding (I may be right or wrong). 

 

If you cross 5 years (i.e.oct 2015), you will not qualify primary home capital gain exemption. However, derpeciation claimed is good.

 

If you are selling before then, you may qualify for primary home. What happens to the period you have receive depreciation is a question. 

 

How much capital gain achieved or how much depreciation or rental loss accumulated (due to depreciation) matters. You need to see which is beneficial for you.

 

If your home (changed to rental A) is giving you positive cash flow, you can keep it as long as you want to hold. Long holding will give you better appreciation and huge depreciation benefit.

 

Better, Consult a CPA for clarity.

 

 

 

Platinum Super Contributor
Nanomug
Posts: 10,370
Registered: ‎05-30-2009
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Re: Selling rental property in 5 years

Capital gains can be complicated.  It's more than sold minus purchase price.  This is generally a tax issue taken up with a tax expert which I am not.  It's been 10 years since I sold a rental and I recall it wasn't bad.

 

My suggestion is to start with looking at a variety of scenerios by using Turbo Tax online.  It's free unless you file.  At least it used to be.  plunk your financial numbers in and then go through the capital gains section.  Change the dates to reflect different sell years.  This doesn't take the place of a tax expert but can give you an idea of what the taxes might be under different situations.  Plus it will give you an idea of documents that you will want to track for capital gains.

 

Bear in mind no one knows if capital gain taxes will change or remain as they are now.  There are changes coming to the tax code and capital gains is one of the areas being looked at.

Gold Regular Contributor
sheriff
Posts: 2,342
Registered: ‎06-01-2012
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Re: Selling rental property in 5 years

[ Edited ]

I believe if you take depreciation on a rental you have to take a bigger hit when you sell it.  Example - if you buy a $400k rental and take $200k in depreciation on it, if you sell it for $600k you pay capital gains on $400k.  If you leave it for your heirs they will have an exemption from much of the capital gains under current law.

Gold Super Contributor
Jil
Posts: 3,135
Registered: ‎10-24-2011
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Re: Selling rental property in 5 years

[ Edited ]

sheriff wrote:

I believe if you take depreciation on a rental you have to take a bigger hit when you sell it.  Example - if you buy a $400k rental and take $200k in depreciation on it, if you sell it for $600k you pay capital gains on $400k.  If you leave it for your heirs they will an exemption from much of the capital gains under current law.


Depreciation is a loss. So Unless it is considered like all other expenses and losses, true profit or loss cannot be ascertained. In other words, depreciation must be considered in order to into out true profit or loss of a business.

 

Value of assets gradually decreases on account of depreciation, if depreciation is not taken into account, the value of asset will be shown in the books at a figure higher than its true value and hence the true financial position of the business will not be disclosed through balance sheet.

 

Taking this as simple case:

 

Scenario 1:

 

No, in this example, there is no capital gain. Assume depreciation is expense for tax purpose.

Taxable amount = sale price - purchase price - depreciation (expense) = 600k - 400k -200k = 0

 

2nd scenario: Supposing you sell it at 550k

 

Taxable amount = 550k -400k -200k = -50k = 50k capital loss, you are allowed take tax deduction every year 3k (it may take 13 years). In case you have some stock which gives you capital gain of 20k on the third year, you can write off capital loss 20k against this capital gain.

 

In this case, first year write off is 3k, 2nd year 3k, third year 20k against capital gain(stock) + 3k regular capital loss,4th year 3k......until it becomes zero

 

3rd scenario:Supposing you sell it at 650k

 

Taxable amount = 650k -400k -200k = 50k (capital gain).  With 2013 rule Long term capital gain is taxed at 20% (IIRC), short term (within an year) is 40%. Assuming long term, you will have to pay 50k* 20/100 = 10k tax.

 

By all means depreciation is considered as expense/loss. 

 

 

 

Silver Super Contributor
ptiemann
Posts: 1,227
Registered: ‎08-07-2009
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Re: Selling rental property in 5 years

[ Edited ]

Yes, depreciation is a 'loss' for tax purposes.

 

I look at it as a loan from the IRS at 0% interest.

 

Example above:

 

Bought house or $400k, turn it into rental, depreciate $200k .. that's $75k less taxes paid over the years you had this rental,

 

then you sell it, yes, your capital gains will be "inflated" by those $200k, and now you pay those $75k back.

 

It was just a 0% loan.

 

For a $400k house, chances are the land was worth $200k and the house $200k, so the annual depreciation should be $200k/27.5 = ~$7k

 

So, with only 5 years, you could have depreciated only ~$36k, not the full $200k as the other person wrote. It would take the full 27.5 years to depreciate the building in full.

 

Once the building is depreciated fully, you probably don't want to sell and pay all those taxes, that's what 1031 exchanges are for. This lets you postpone the tax payment further.

 

Timing is another issue. There may be a year in your life (or more than 1), when you have no income and/or big losses. A good time to sell.

Further the tax rate can change. Chances are, taxes will be higher in 20 years than today. Something to consider.

Silver Super Contributor
ptiemann
Posts: 1,227
Registered: ‎08-07-2009
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Re: Selling rental property in 5 years

[ Edited ]

Jil wrote:

sheriff wrote:

I believe if you take depreciation on a rental you have to take a bigger hit when you sell it.  Example - if you buy a $400k rental and take $200k in depreciation on it, if you sell it for $600k you pay capital gains on $400k.  If you leave it for your heirs they will an exemption from much of the capital gains under current law.


Depreciation is a loss.

 

[..]

 

Scenario 1:

 

No, in this example, there is no capital gain. Assume depreciation is expense for tax purpose.

Taxable amount = sale price - purchase price - depreciation (expense) = 600k - 400k -200k = 0

 

 [..]

 


 

Unless I read this out of context, I don't think that this is correct. I believe the correct formula is:

 

Taxable amount = sale price - purchase price + depreciation

 

Note the PLUS instead of MINUS near the end.

 

The depreciation is a paper loss. A phantom loss, that you did not really suffer. Yes, buildings depreciate, but with minimum maintenance, do they really become worth $0 after 27.5 years??

 

The process of ADDING the past years' depreciation is called RECAPTURING.

http://en.wikipedia.org/wiki/Depreciation_recapture

 

Gold Regular Contributor
sheriff
Posts: 2,342
Registered: ‎06-01-2012
0

Re: Selling rental property in 5 years

[ Edited ]

ptiemann wrote:

Jil wrote:

sheriff wrote:

I believe if you take depreciation on a rental you have to take a bigger hit when you sell it.  Example - if you buy a $400k rental and take $200k in depreciation on it, if you sell it for $600k you pay capital gains on $400k.  If you leave it for your heirs they will an exemption from much of the capital gains under current law.


Depreciation is a loss.

 

[..]

 

Scenario 1:

 

No, in this example, there is no capital gain. Assume depreciation is expense for tax purpose.

Taxable amount = sale price - purchase price - depreciation (expense) = 600k - 400k -200k = 0

 

 [..]

 


 

Unless I read this out of context, I don't think that this is correct. I believe the correct formula is:

 

Taxable amount = sale price - purchase price + depreciation

 

Note the PLUS instead of MINUS near the end.

 

The depreciation is a paper loss. A phantom loss, that you did not really suffer. Yes, buildings depreciate, but with minimum maintenance, do they really become worth $0 after 27.5 years??

 

The process of ADDING the past years' depreciation is called RECAPTURING.

http://en.wikipedia.org/wiki/Depreciation_recapture

 


The issue here is do you need the tax loss now?  If you are in a high tax bracket, take it.  If you are in a low tax bracket, or no tax, it would be wise to not depreciate you asset.  Example:  Say you are semi-retired with an income of $40,000.  You  have 5 rental properties, each with a small positive cash flow.  You will be in a low tax bracket and will pay very little income taxes.  You can either not take depreciation or do it on only one property and it will actually save you money in the long run.  If your income is $200,000,  you will want to depreciate all the properties.

Super Contributor
Meguro
Posts: 326
Registered: ‎11-30-2009
0

Re: Selling rental property in 5 years