Omitting depreciation expense is one of the most common tax mistakes made by landlords. By including depreciation expense on Schedule E, your total rental expenses increase and you are more likely to have a total rental real estate loss. This will also lower your AGI and possibly increase your refund.
The IRS allows you to depreciate the value of your rental property, minus land value, over 27.5 years (its useful life). This means the IRS believes your property will be worth $0 after 27.5 years.
Ex: Your home, including land, is valued at $400,000 on the date it became a rental and for the purposes of this example, your land is valued at $50,000. Your basis for depreciation is $350,000 ($400,000 – $50,000). Check with your county tax assessor to get your actual values. Divide your basis by 27.5 years to determine your annual depreciate expense. In this example, you’re allowed to deduct $12,727 ($350,000 / 27.5) on Schedule E, line 18 every year until you have fully expensed your rental property.
While you were a landlord, the IRS allowed you to take advantage of this tax benefit under the assumption you would keep your property for its entire useful life. If you sell your rental property above the depreciated value before it’s been fully expensed, you’ll be required to pay a maximum 25% tax on your accumulated depreciation recapture income – also know as an unrecaptured section 1250 gain.
Ex: If rent the property above for 5 years you will accumulate $63,635 ($12,727 x 5) in depreciation expense. When you sell the property, you are required to pay 25% of your accumulated depreciation recapture income, or $15,909 ($63,635 x .25).
Taxes on depreciation recapture are due in addition to capital gains taxes paid on any profit from the sale of the property on both your federal and state returns. Understanding the taxes owed will help you determine when it is best to sell your property and for how much. I advise my clients to either save their additional income tax refund every year or ensure they make enough profit when selling their home to offset the large tax bill down the road.
This is a simplified explanation of deprecation expense and recapture. Contact me for assistance with your unique situation.