01/22/07: Capital Gains Tax and Depreciation
By Benny L. Kass
(Fourth in a Series)
The income tax has made more liars out of the American people than golf has.
Will Rogers, Illiterate Digest (1924)
If you have made a profit when you sell your house, you may have to pay some income tax. Last week, we discussed the exclusions of up to $250,000/500,000 for your principal residence.
But what if you made more profit than you can exclude? Or what if you used a portion of your home as a “home office”? Or what if the property you sold was rented out for a period of time?
How do you determine profit? The IRS explains this with the following formula:
- Selling Expenses/Amount Realized
- Adjusted Basis/Gain (or loss)
(IRS Publication 523, Selling Your Home. This is available on the web at www.irs.gov, and click on “Publications”.)
Let’s take the following example. You bought your house for $290,000 and at settlement paid $10,000 in closing costs (such as title search, survey, legal fees). Your basis is $300,000. Several years later, you added a room to your house at a cost of $50,000 and now your adjusted basis is $350,000.
You have now sold your house for $635,000. In order to accomplish this, you paid a real estate commission of $30,000, legal and settlement fees of $2,000, and miscellaneous expenses of $3,000. To determine the “amount realized” you deduct these costs ($35,000) from the selling price, and come up with $600,000.
Many homeowners want to deduct the amount of their outstanding mortgage when calculating gain. That just will not work. You cannot take your mortgage into consideration when you are determining your profit. It is, of course, useful to determine how much money you can take to the bank after the house is sold.
Looking at the formula stated earlier, your gain is $250,000 ($600,000 - 350,000). Since you have owned and lived in the house for two out of the last five years before the house was sold, you are eligible for the up-to $500,000 exclusion of gain ($250,000 if you are single or file a separate income tax return).
On the other hand, if your gain was more than $250,000 – or if you are not eligible for the $500,000 exclusion – you will have to pay the IRS a capital gains tax based on 15 percent of that profit. You may also have to pay a State or local tax on this gain.
Now, let’s add another fact to our scenario. You worked from home, and over the years claimed $3,000 in depreciation for your home office. In order to qualify for the home-office deductions, that portion of your house must be used regularly and exclusively for your business. If you let your kids play in that area, or you also watch the Sunday football games there, no deduction is permitted.
Here’s the tricky part. The IRS allows taxpayers to depreciate that portion of the home which is used for your business. If, for example, the depreciation formula would have allowed you to deduct $5000, even though you have only deducted $3000 in our example, you will have a taxable gain of $5,000.
The regular capital gains tax for most taxpayers is 15 percent. However, the tax on the depreciation (called “recapture tax”) is at a maximum rate of 25 percent. And you have to report that on Schedule D (entitled Capital Gains and Losses).
According to the IRS:
If you were entitled to take depreciation deductions because you used your home for business purposes... you cannot exclude the part of your gain equal to any depreciation allowed or allowable as a deduction for periods after May 6, 1997. If you can show by adequate records or other evidence that the depreciation allowed was less than the amount allowable, the amount you cannot exclude is the amount allowed. (IRS publication 523 at p. 17).
Does this convoluted language make any sense? According to Julian Block, a New York tax attorney and author of The Home Seller’s Guide to Tax Savings, “this term is IRS-speak for what (the taxpayer) claimed previously, or, if she claimed less than she could have claimed, the amount that she could have claimed.” The former is the “amount allowed” and the latter is the “allowable amount”.
Keep in mind that “recapture tax” and “basis” are two different concepts. Whether or not you actually took a depreciation deduction for your home office, your basis must be reduced. For example: the IRS will allow you to have taken $10,000 in depreciation for your house over the years. If you actually deducted that amount, your basis will be reduced by the full $10,000. However, even if you only depreciated $5000, (which had the effect of reducing your basis down to that amount), you will still have to reduce your basis by another $5,000.
In other words, depreciation reduces your property’s “basis”. You must reduce basis by the full amount of what is allowable as depreciation, even if you only claim a portion of that allowable amount.
But even though you must reduce basis, that does not mean that you have to pay the recapture tax. This tax is based on the amount that you actually deducted on your previous tax returns. And if you never claimed depreciation? Then, says attorney Block, there is no recapture. According to Mr. Block, “even though the amount you take is recaptured and taxed when you sell the house, you are probably going to save money by taking the deduction now and paying tax on it later.” (For more information about his book, go to www.julianblocktaxexpert.com).
Now, let’s change the facts a little more. You bought the house on January 15, 2001 and lived in it until March 15, 2003. You then rented it out, but sold it in February 15, 2006. Since you have lived and owned the property for the requisite 2 out of 5 years (called the ownership and use test by the IRS), you are eligible to take the exclusion.
However, if you depreciated the property during the period that it was rented, the same analysis described above would apply. You would not be able to exclude that part of your profit equal to the recaptured depreciation you deducted while renting your house.
This is extremely complicated, and if you have not lived in your house for at least two years before the projected sale date, familiarize yourself with the rules and consult a qualified tax professional. For example, let’s say that you only lived there for 22 months before it was rented out. Depending on the time frame, you could move back into the house for two more months, and then claim the full exclusion. It should be noted that the two year period of use and ownership does not have to be consecutive. So long as you have lived in your house for a period of 24 months over the five years before the house is sold, you are eligible for the exclusion of gain.
It would be a shame if you lost the opportunity to exclude up to $500,000 just because you were two months shy of that goal.
Next: The Starker Exchange