Depreciation recapture on personal residence - Posted by Brian

Posted by Frank Chin on November 25, 2006 at 10:19:42:

Chris:

Dave gave some excellent examples.

Just to add, in my neighborhood, years back, they upzoned, and SFH sitting on large lots can be torn down and replaced by three two family houses.

Older SFH, needing some rehab might sell for 450K only as a SFH. A builder needing a lot would glady pay 550K for each house, spend a million to demolish the SFH, and replace it with three 2 family homes, and sell them currently for 990K each.

So what is the “land value” of the current 450K homes selling as SFH??

A while back, I did a preforeclosure where the ARV of a home is 125K to 130K. The seller was getting offers from builders for 60K, the land value. He was ready to do a deal for 70K just to pay off his loans. After the purchase, I booked the building asset at 70K. Technically, I can book 10K for the building, and 60K the value of the land.

Because normally, land/building is 20/80, I depreciated 80% of 70K. Had I decided to book 60K for the land, I beleived it’s more than justified.

In fact, from time to time, the insurance updates my properties, and it cost about 300K to rebuild a brick 2 family home. Yet, they sell for 850K nowadays, which indicates to me the land cost alone is well over 500K for each.

Frank Chin

Depreciation recapture on personal residence - Posted by Brian

Posted by Brian on November 23, 2006 at 22:51:47:

I have a feeling that “ask a CPA” might be the answer to this one, but here goes…

After unsuccessfully trying to sell my personal residence, I gave up and am renting it out. Looks like a lease option is going to be possible here.

My current basis in the house is $215k. Because of a stagnant market, the negotiated option exercise price will be…$215k. As I moved out of the house in August 2006, I know that I can be exempt from capital gains taxes if I close on the house (ie, the option is exercised) before August 2009.

Assuming that I claim depreciation on the house during the life of the lease, must I recapture the depreciation at the time the option is exercised? Given that the option exercise price is equal to my current basis, do I have any incentive to have the tenant/buyer exercise the option before August 2009, or is this all a wash? Or is there any tax strategy that I should be considering to maximize after-tax profits?

You don’t have to recapture depreciation - Posted by David Krulac

Posted by David Krulac on November 25, 2006 at 14:29:25:

on a personal residence converted to an investment property OR an investment property converted to a personal residence for any depreciaiton taken before like May 5, 1997.

I know that this doesn’t apply to you, Brian, but wanted to add that for others for which that might apply.

Re: Depreciation recapture on personal residence - Posted by David Krulac

Posted by David Krulac on November 24, 2006 at 07:36:50:

depreciation is based on your ORIGINAL purchase price not the current value. The IRS cares nothing about your current value.

You can elect not to take depreciaiton, however when sold the IRS form calls for depreciation taken OR allowed.

One tax strategy is to minimize depreciation. IRS says 27.5 years for residential MINIMIUM. You can stretch out depreciationfor longer periods. For example you can depreciate over 50 years instead of 27.5.

Another tax strategy would be to have a high valuation for the land, which is NOT depreciable. Land is NEVER depreciated.

There are several bits of info missing to provide adefinate answer like, when bought, how long you lived there, purchase price etc.

Depreciation recapture is 25% currently and long term capital gains for most people is 15% currently. For every dollar that you can legally convert from deprecaition to appreciaition you will save 10 cents on your income tax. But as a practical matter depreciation for a short period could be realative small.

Re: Depreciation recapture on personal residence - Posted by DavidB

Posted by DavidB on November 24, 2006 at 07:32:14:

Brian,
I’m not a CPA, but I don’t think you should be claiming depreciation on
your personal residence. Depreciation is only available on an
investment property. For the home you can deduct interest and taxes
only. Perhaps you can file an amended return, but in that case I’m sure
the IRS will tax the mistakenly-taken depreciation. So it seems like
either way you go, claiming it as an investment property or as your
personal residence, you still will have recapture of the depreciation. Do
you have any other net losses from other real estate that could reduce
the recaptured depreciation?

Re: Depreciation recapture on personal residence - Posted by Brian

Posted by Brian on November 25, 2006 at 13:32:05:

Thanks to all for the replies. My ORIGINAL basis in the property is $215k. That reflects my original purchase price plus capital improvements.

I moved into the house in 2001 and lived there until August of this year. Other than calculating the exemption period for capital gains of a personal residence, how does that matter? (It will be a rental starting next month.)

If the option is exercised before 2009, it’s my understanding that I won’t have to pay ANY capital gains tax. Even though the option exercise price = current basis (both are $215k), over the life of the lease option, I will have to adjust my basis because of the depreciation claimed.

So my cost of having the tenant/buyer NOT exercise the option before August 2009 is paying capital gains tax on the amount of depreciation claimed between December 2006 and July 2009. Not a lot of money either way (I think).

Have I analyzed this correctly, or am I missing something?

Re: Depreciation recapture on personal residence - Posted by Dave T

Posted by Dave T on November 25, 2006 at 12:09:09:


You can elect not to take depreciaiton, however when sold the IRS form calls for depreciation taken OR allowed.

I believe the correct terminology is “or allowable”, whichever is greater.

Since the IRS requires a 27.5 year recovery period for residential rental property, the recapture will be based on a 27.5 year straight line depreciation schedule.

A word of caution… - Posted by Christopher Smith

Posted by Christopher Smith on November 24, 2006 at 09:07:11:

I?d be cautious about having ?a high valuation for the land? as a ?tax strategy.? Not only is this an ethical consideration, it?s also a path into hot water with the IRS. Intentionally misrepresenting the split between land value and structure value to either increase depreciation (to lower income taxes) or decrease depreciation (to lower capital gains tax) will get you the wrong kind of scrutiny from your favorite auditor.

Re: Depreciation recapture on personal residence - Posted by Brian

Posted by Brian on November 25, 2006 at 13:33:33:

Christopher is correct. I was not intending to depreciate my personal residence for the period in which it was a personal residence. Rather, since it’s being converted to a rental next month, I would be claiming depreciation on the property as a rental property from next month onward.

Re: Depreciation recapture on personal residence - Posted by Christopher Smith

Posted by Christopher Smith on November 24, 2006 at 09:09:25:

He can claim depreciation once he puts it into service as an income generating rental property.

Re: Depreciation recapture on personal residence - Posted by David Krulac

Posted by David Krulac on November 25, 2006 at 14:35:04:

you look good from a tax prespective. Basis = $215K and Sale Prcie = $215k, therefore no capital gains tax.

The depreciation would be recaptured only from Dec, 2006 to July 2009 at 25% rate.

Be careful about your move out date and if there is a gap between living there and renting there.

Also be extremely careful on the 2 out of the last 5 years as a personal residence. You want to make certain that the optionee does not extend the option and that they settle on time. Settling early would be ok, but a delayed settlement could screw up your time frames. But since you don’t have any capital gains I guess that’s a mute question. Good Luck to you.

Sorry, but you’re wrong on 3 counts… - Posted by David Krulac

Posted by David Krulac on November 25, 2006 at 14:24:15:

  1. IRS provides for depreciation taken or allowed, there is no whichever is greater, you made that up.

  2. the 27.5 years in a MINIMUM, designed to disallow people who want to use SHORTER depreciaiton schedules.

  3. The IRS does not care if you take longer depreciation schedules as long as there is a rationale and justification for that.

  4. You are absolutely right when you say that you must take depreciaiton, but the rest of what you say is horse hockey.

its NOT unethical… - Posted by David Krulac

Posted by David Krulac on November 24, 2006 at 13:59:03:

and I would not advise anybody either here on this board or anywhere else to do anything unethical. This strategy was actual suggested to me by an IRS agent during an audit.

I’m not suggesting and neither was the IRS to mis-represent the value of the land. Au contrare, the biggest component in the price escalation of houses is the value of the land. The costs of developing a raw piece of land has escalated tremendously over the last 6 years or so. There are much more regulations and governmental approvals to get in order to build. In my area the price of houses has doubled butthe price of land as quadrupled. Some would argue that almost all of the real price increase of houses is due to the land.

There is one situation I know where a person bought a house for $180,000 and tore the house down to build a new house. Traditionally the value of that lot might be 20% of the purchase price, however in this case the value of the land is 100% of the pruchase price since the house was torn down. In another case a bank bought a house for $500,000 and tore down the house to build a bank. The value of the land IMHO is 100% or $500,000.

I fail to see any ethical considerations, unless you are trying to pull some fraud. When the IRS tells you do do something, I don’t see how its unethical.

Also lowering depreciaiton INCREASES your capital gain tax not decrease as you stated.

It used to be that some CPAs suggested that you use the Tax Assessors land-building split or an arbitary flat 20%. I believe that while that might be a save approach, it is neither mandated or may not be even financially correct. There are many properties where the building is worth a lot less than 80% of the value, and where the assessment split does not necessairly align with the current economic situation.

Plus the whole argument is mute; you can lower depreciaiton on any property by extending the depreciaiton schedule for a longer period. I’ve used
50 years and had it approved by the IRS, no problem. They are concerned if you take TOO MUCH depreciaition, they are not concerned if you take TOO LESS, as that results in more current taxes.

Re: its NOT unethical… - Posted by Bob Smith

Posted by Bob Smith on November 25, 2006 at 10:14:47:

We all know that if you take no depreciation, the IRS will force you to take a 27.5 year depreciation schedule whether you want to or not, since the tax code generally requires you to take all allowable depreciation. A 50 year depreciation schedule clearly isn’t all allowable depreciation, so I’m curious why the IRS allowed it.

Re: its NOT unethical… - Posted by Christopher Smith

Posted by Christopher Smith on November 24, 2006 at 15:31:05:

Ethics: My only point is that ?to have a high valuation for the land? is not a strategy. For a given property there is not much one can do to increase or decrease the value of the land ? there is only one acceptable approach: to attempt to value it as accurately as possible.

My intention was not to question your personal ethics (apologies if my comment was inferred as such) ? it was simply to point out that some readers might interpret ?to have a high valuation for the land? as simply changing the number. I?ve had aggressive accountants give me this advice before. It?s something to look out for, and in my opinion worth mentioning.

Depreciation: Increasing depreciation results in an increase in capital gains tax. You pay capital gains on the net sales price minus the adjusted basis. In order to calculate the adjusted basis you take the original cost basis, add cost of improvements, and subtract all depreciation. Higher depreciation => lower adjusted basis => higher capital gains tax.

But overall I agree with you that in some areas the value of the land trumps the value of the structure.

Re: its NOT unethical… - Posted by David Krulac

Posted by David Krulac on November 25, 2006 at 10:52:51:

The IRS allows it becasue they get MORE current taxes the less depreicaition that you take. The 27.5 years is a minimum, not a maximum and not even a requirement.

Plus in certain circumstances if you are not a real estate professional and your real estate depreicaition and other losses exceed $25,000, you have to carry forward losses essentially depreiciation. so while one section of the IRS code says that you must take depreciaiton, another section says you can’t take more than $25,000 under certain circumstances.

Prior to 1987 the tax code allowed more than $25,000 excess Real estate losses to go against other non-passive income. There were circumstances where people would have $100,000 of real estate losses and $100,000 W-2 income and have no Federal Income tax due. SWEET.

Re: its NOT unethical… - Posted by David Krulac

Posted by David Krulac on November 24, 2006 at 17:27:36:

I think we must agree to disagree.

There is not 1 value for a piece of land. There is FMV, there is asssessed value, there is the highest and best use value, there is the value with the structure removed value, etc. etc. etc.

Two apprasiers could come up with and often do, a different value for the entire property and likewise would probably come up with a different land/improvement split.

You need a rationale and justification if you are going to use a land /improvement split that is not as conventional as 20% to 80% or the assessment figures. You will need in an IRS audit to defend this action as well as every other action on your return.

Recently a house sold for $100,000 on the same street where a lot sold for $40,000. I would easily use this as justification for the land split. Two hands length transactions one improved, one vacant lot on the same street. Pretty compelling IMHO, even though its double the accepted 20%. I think its totally justified and black and white not gray.

Another example a older farm house on 2 acres sold for $150,000, the rest of the farm was divided into other 2 acre lots totally vacant. These vacant lots sold for $100,000. Ergo the farm house was worth $50,000 and the land under it was worth $100,000. Instead of the “standard” safe 20% land value the land value here could easily be substantiuated to be 66%.

There is not one correct answer here, is the point, under certain conditions, the land value could fluctuate up to 100% in the case of a tear down.

The opposite is true also. If you wanted to maximize your depreciation, within reason, good sence and ethics, the land value can be lower and the improved value increased.

An example of that would be a substandard size, zoning or location of a property. Say a lot is less than the minimium size now required and the house is destroyed. Some areas grandfather that non-conformity for only 6-12 months. If you don’t rebuild in that time, the lot becomes unbuildable.

Or lets say the house is in a flood zone and the law forbids rebuilding if more than 50% of the structure is destroyed. You have a flood damage of more than 50%, now you have an unbuildable lot. What is its value? I would agrue very low. The difference between a buildable lot and an unbuildable lot could be 80% to 90%, the way I see it. It could be setback requirement, it could be lot maximum coverage requirement or any other zoning requirement.

The bottom line is that for an indivdual property there is latitude under the law for different valuation splits between land and improvement. As long as you can justify the split that you apply you should be in good shape with the IRS. And if you have a legal, rational, and ethical justification for your actions the IRS can not hit you for fraud.

Re: its NOT unethical… - Posted by Eric in FL

Posted by Eric in FL on November 25, 2006 at 22:35:53:

You can still take advantage of this wonderful provision in the code if your wife is a real estate professional and you are a highly paid W2 executive. Life is good.

-Eric

Re: its NOT unethical… - Posted by Chrisotpher Smith

Posted by Chrisotpher Smith on November 24, 2006 at 17:32:47:

No need to agree to disagree; I pretty much agree with you.

Good examples - I get your point.

Re: its NOT unethical… - Posted by Brian (NoCA)

Posted by Brian (NoCA) on November 28, 2006 at 16:30:08:

Another example on the opposite extreme. Just bought an older muti-family for $72k. I can easily show that new construction of a replacement is financially infeasable, in other words the potential income cannot support new construction. So what is the value of the land? I would argue minimal, because who the heck would buy such a piece of land that you cannot build on now, or expect to build on in the near future? The guy next door might, but that would represent an investment value and not a market value. I have no bones about using an improvement allocation of 95%. Like Dave said, if you can reasonalby support it, don’t be afraid to use it.