Taxation on the Sale of Your Home with a Focus on Depreciation – Part 2

 

Jane Young, CFP, EA

When you sell a home that has been rented there are restrictions on your ability to exclude all of your gains.  As mentioned in last week’s article, you may be able to exclude up to $250,000 in gains if you are single and up to $500,000 if married filing jointly, assuming you have lived in your home for 2 of the past 5 years.  However, after January 1, 2009, this exclusion is limited to the gain associated with the time your home was used as a primary residence.  You cannot exclude any gain that may be attributable to depreciation allowed after May 6, 1997.

When you rent your home, the IRS allows you to take a depreciation deduction. This enables you to spread the cost of your property over time and temporarily shelter some of your income from taxes.  Residential homes are usually depreciated over 27.5 years using the fair market value (FMV) of the property at the time you began renting the property.  Only the building can be depreciated so you need to subtract the value of land from your FMV before calculating depreciation.

Depreciation can be a great way to shelter taxes, at least while you are renting your home.  However, when the property is sold you cannot exclude any gain equal to the depreciation allowed or taken, even if you lived in the home for 2 of the last 5 years.  The IRS refers to this as unrecaptured Section 1250 gain or depreciation recapture and this is taxed at a maximum rate of 25% instead of capital gains rates.  You may be tempted to forego taking the depreciation deduction to avoid the 25% depreciation recapture.  However, this is not a good idea because the IRS calculates recapture on allowable depreciation not depreciation actually taken.

If you have a loss on the sale of your home you may be able to escape recapture of depreciation. When calculating the gain or loss on the sale of your home, depreciation is deducted from your adjusted basis.  If you still have a loss after deducting depreciation you will have no gain from which you need to recapture depreciation.

On the other hand, if you anticipate a substantial gain and think it may be advantageous to postpone a large tax hit, consider a 1031 exchange also known as a like-kind exchange.  The IRS rules regarding 1031 exchanges are very stringent and can be quite complex.  If you are considering a 1031 exchange it’s advisable to work with a tax professional that specializes in this area.

 

More to Rental Property Than Meets the Eye

 

Jane Young, CFP, EA

Jane Young, CFP, EA

With low interest rates and the fear of another drop in the stock market, many people are looking for alternative ways to earn investment income.  Many investors find the tangible nature of real estate appealing.  Although real estate may seem like the logical alternative to stocks and bonds, investment in real estate can be very complex, time consuming, and wrought with risk. 

Before buying, perform a realistic cash flow analysis on the income and expenses associated with the property you are considering.  Begin with start-up expenses associated with acquiring the property, including the down payment and any necessary improvements. Next tabulate the routine expenses that you will incur with a rental.  These may include mortgage payments, insurance, property taxes, home owner’s association dues, routine maintenance, and legal and accounting fees.  As a rule of thumb, maintenance and repairs run about 1-2% of the market value of your home, depending on the home’s condition.  Also consider an emergency fund to cover large unexpected repairs. 

Managing rental real estate can be very time consuming.  Seriously think about whether you want to manage the rental yourself or you want to hire a property manager.  Do you have the time and the desire to manage the property? If you do it yourself, you will need to market the property, evaluate potential renters, maintain the property, respond to tenant issues, collect rent payments and potentially evict tenants.   You also may want to learn about fair housing laws, code requirements, lease agreements, escrow requirements, and eviction procedures.  If you don’t have the time or the temperament to manage the property, consider hiring a property manager.  Property management fees usually run about 10-12% of rental income.

Some additional risks to consider when renting property include the possibility of major damage inflicted by a tenant, drawn out eviction processes, and law suits for negligence and safety issues.

After evaluating your expenses, do some income projections.  Research rents paid for similar properties in your target neighborhood.   Be sure to incorporate a reasonable vacancy rate.  According to the Colorado Division of Housing, the average vacancy rate in Colorado Springs has been about 6%, for the last 4 quarters.

Include the tax benefit of deducting depreciation into your analysis.  To calculate annual depreciation, divide the initial value of your rental home, not including land, by 27.5.  Unfortunately, you will probably have to recapture (repay to the IRS) this deduction upon sale of the property at a maximum rate of 25%.

Subtract your projected expenses from your projected income to determine your net profit.  Will the net profit you expect to gain from the property compensate you for your capital, time and risk?  In addition to the profit from rental income, be sure to factor appreciation of your property into your analysis.  Additionally, if you have a mortgage, your equity will increase every year as you pay off your mortgage.