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Just a simple example that helped me understand depreciation recapture: Say you buy a rental for $200k (with land worth $40k). You can depreciate $160k (building only) over 27.5 years = about $5,818/year. You own it for 5 years, claiming $29,090 total in depreciation. You sell for $220k. Most people think: I bought at $200k, sold at $220k, so my profit is $20k. IRS thinks: Your adjusted basis is $200k - $29,090 = $170,910. Your total gain is $220k - $170,910 = $49,090. Of that gain, $29,090 is depreciation recapture (taxed up to 25%) and $20k is capital gain (taxed at lower capital gains rates). This is why you pay tax on more than just the $20k difference between buying and selling prices.
Thanks for this breakdown - super helpful! Quick question: If I sell a rental after owning for the full 27.5 years, would I still have depreciation recapture? Or would it be fully depreciated at that point?
If you sell after the full 27.5 years, you would still have depreciation recapture, but it would be on the entire depreciable amount of the building. After 27.5 years, your basis in the building portion would be $0 (assuming no improvements were made along the way). So if you sold, all of the building portion of your sale price would be subject to depreciation recapture at the 25% rate. The land portion would be calculated separately as a capital gain. Many investors avoid this recapture tax by doing 1031 exchanges into new properties, which allows you to defer both the capital gains tax and the depreciation recapture tax. However, this is just deferring the tax - not eliminating it completely.
Does anyone know if you can avoid depreciation recapture if you convert your rental back to a primary residence before selling? I've heard conflicting things about this.
Unfortunately, converting to a primary residence doesn't help with depreciation recapture. You'll still have to pay recapture tax on ALL depreciation taken while it was a rental. The primary residence conversion can help with capital gains (you might qualify for the $250k/$500k exclusion), but the IRS specifically requires recapture of depreciation regardless of the property's status when you sell. The only way to avoid recapture is with a 1031 exchange into another investment property, but that just defers it - you'll face recapture eventually when you finally sell without exchanging.
Something nobody's mentioned yet - if you owe $28k, make sure you're aware of the different payment plan options. For amounts over $25k, you typically need to provide additional financial information and the approval process takes longer. If you can get your balance under $25k (by making a partial payment), you can qualify for a streamlined installment agreement which is much faster to set up. Just something to consider while you're waiting for the official details.
This is really helpful - I had no idea there was a threshold at $25k! Do you think I should try to pay $3k now to get under that limit? Would that speed things up or just complicate the application I already submitted?
Making a payment to get under the $25k threshold would definitely help speed things up. The streamlined process is much simpler and typically processes faster. It won't complicate your existing application - the IRS will just see that you've made a payment and recalculate your plan based on the new balance. Just make sure you use Direct Pay on the IRS website and select the correct tax year and reason for payment (installment agreement request). A $3k payment now would also save you quite a bit in penalties and interest over time.
Has anyone used the IRS2Go app for this kind of situation? I heard you can make payments through it even if your payment plan isn't finalized yet.
Yes! The IRS2Go app is actually really good for making payments. It links directly to IRS Direct Pay and the other payment processors. I used it last year when I was in a similar situation and it worked perfectly. The interface is much easier than navigating the main IRS website.
Don't overthink this. I've done private loans for three different properties. The key is documentation, documentation, documentation. Make sure your loan has: - Clear terms written down and signed by both parties - A reasonable interest rate (even if it's very low) - A defined repayment schedule - Regular payments that you can track If it's a family member, be aware of gift tax rules. If they're charging no interest or below-market rates, there could be some imputed interest issues as others mentioned.
What exactly counts as "reasonable" interest? My parents want to charge me 1% interest on a house loan which is obviously way below market rate. Is that going to be a problem?
The IRS publishes what's called the Applicable Federal Rate (AFR) each month, which is the minimum interest rate they consider legitimate for loans. These rates are typically lower than commercial rates. For example, as of last month, the long-term AFR (for loans over 9 years) was around 3-4%. If your loan charges less than the applicable AFR, the IRS might "impute" interest, meaning they treat the loan as if it charged the minimum rate even if it doesn't.
Has anyone actually been audited over a private loan? I borrowed $200k from my grandparents for my house last year and we didn't create any formal paperwork because, well, they're my grandparents. Now I'm worried...
Without proper documentation, the IRS could potentially reclassify that $200k as a gift rather than a loan, which could have significant consequences. The annual gift tax exclusion is only $17,000 per person (as of 2023), so amounts beyond that would count against your grandparents' lifetime gift/estate tax exemption.
Something no one has mentioned yet - if you made improvements to your house during ownership, those costs increase your basis which could lower your gain even more. Things like a new roof, kitchen remodel, additions, etc all count! Make sure you have receipts though.
Thanks for pointing this out! We actually did a bathroom remodel (~$22k) and replaced all the windows (~$15k) a few years ago. I have receipts for everything. Do these improvements get listed somewhere specific on the tax forms?
You'll add those improvement costs to your original purchase price when calculating your adjusted basis on Form 8949. So if you bought the house for $200k and did $37k in improvements, your adjusted basis would be $237k. The difference between your selling price (minus selling expenses) and this adjusted basis is your actual gain for tax purposes. This means your real gain is likely even lower than you initially calculated, putting you even further below the $500k exclusion threshold. Still need to report it though!
Can someone explain EXACTLY where on Schedule D this goes? My tax software is confusing me with all the different sections and I'm selling my house this year too.
You'll list it on Form 8949 first (Part II for long-term holdings) with code "H" in column (f), then the excluded amount as a negative number in column (g). Then the totals flow to Schedule D, Line 8. If you're using software like TurboTax or H&R Block, they should walk you through this if you tell them you sold your primary residence.
Misterclamation Skyblue
One thing nobody mentioned - if you're doing renovations before renting, keep EXTREMELY detailed records of everything. Take before and after photos of all work done. I got audited last year specifically on my rental property improvements and had to prove which were repairs vs capital improvements. The difference in tax treatment is huge.
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Peyton Clarke
ā¢What counts as "detailed records"? I've been keeping receipts but not much else. Should I be doing more?
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Misterclamation Skyblue
ā¢Receipts are a good start, but you should also note exactly what each expense was for. Create a spreadsheet that categorizes everything as either a repair or improvement. Take dated photos before, during, and after major work. Keep copies of contracts with any contractors. For example, don't just have a receipt that says "bathroom work - $3,500." Have documentation showing it was a complete bathroom remodel with new fixtures, tile, etc. This makes it clear it's a capital improvement rather than a repair. The IRS can get very picky about what qualifies as an immediate deduction versus what must be depreciated.
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Vince Eh
Has anyone used TurboTax for reporting rental property? I've used it for years for my personal taxes but never for a rental. Not sure if it can handle all the depreciation and improvement tracking properly.
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Sophia Gabriel
ā¢I've used TurboTax for my two rental properties for about 3 years. It works fine for basic rental situations but gets confusing with complex renovations. There's a section specifically for rental properties where you can enter all your income and expenses. It'll walk you through depreciation too.
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