Question: I am planning to sell a residential rental property for about $1 million. I purchased the property 30 years ago at a cost of $350,000 (allocated 250,000 to the building and $100,000 to land). The building has been fully depreciated. I have been told by my accountant that I will have to report a capital gain of $900,000 before closing costs. It doesn’t seem fair. Is this true?
Answer: Depreciation represents a deduction for the reasonable allowance for the exhaustion, wear and tear of property used in a trade or business, or of property held for the production of income. Depreciation is not allowable for property used for personal purposes, such as a residence or a car used solely for pleasure. Land is not depreciable.
Throughout the past 30 years, you have been taking advantage of the building’s depreciation deduction on your individual tax return. The depreciation deduction has been used to offset your rental income. However, as the building was being depreciated, your tax basis in the building has been reduced by the same amount.
Your accountant is correct in his calculation. Here is why:
The original cost basis of land and building is $350,000. Subtract $250,000, the acumulated depreciation of building. The tax basis of land and building at time of sale is $100,000.
Your gain on the sale is $900,000, the difference between the sales price of $1 million and your tax basis of $100,000. I understand your dismay about having to pay tax on a $900,000 gain rather than the $650,000 ($1,000,000 selling price less the original cost of $350,000) you expected. Once again, you have already received the tax benefit of the depreciation throughout the years, and now you have to pay for that benefit! Believe it or not, you are actually ahead of the IRS. In your case, you have deducted depreciation against income taxed at high ordinary tax rates, but you will be paying most of your tax now at a lower capital gain rate. However, when you sell a residential rental property, the depreciation you claimed is “recaptured” and taxed as ordinary income, typically at a maximum federal rate of 25% (known as Section 1250 recapture), even if your overall capital gain might be taxed at lower rates.
Barry Dolowich is a certified public accountant and owner of a full service accounting and tax practice with offices in Monterey. He can be reached at (831) 372-7200. Please address any questions to PO Box 710 Monterey, CA 93942 or email: bdolowich@gmail.com
