Is Depreciation Optional?

Q: Tax Playa, I own a rental property, but don't want to worry about taking depreciation deductions.  Can I opt out of them?
Bill, Huntington VA

A: Depreciation is technically optional, as is any deduction.  However, you are required to "recapture" depreciation claimed or that could have been claimed.  Therefore, not taking depreciation when you are entitled to is a costly mistake...

For more information on depreciation, see what I wrote about it earlier.

Depreciation is a tax provision that allows you to slowly recover, or depreciate, the cost of a business asset.  Most of the time, assets you depreciate for tax purposes also depreciate in the real world.  For example, the depreciable life of a computer is five years, which roughly corresponds to its life in the business world.  Expensing is a type of depreciation on assets which allows a full deduction in the first year.  For most businesses, then, taking depreciation is a no-brainer.  Whether it is in the first year or over time, it is the only way the tax code allows you to recover the costs of your assets.

One aspect of depreciation is more vexing: buildings.  These generally go up in value, not down.  As such, people often don't see why they are "depreciating" something that is, in fact, "appreciating."  This is why it's important to recognize that depreciation is better thought of as "cost recovery."  Buildings depreciate over one of the following three lives:

1. 27.5 years, if it's a residential rental structure
2. 39 years, if it's a non-residential structure
3. 40 years, if the depreciating taxpayer is in AMT

In all cases, the depreciation takes place using the mid-month, straight-line convention.

Upon sale of the asset of a building, there are usually two capital gains:

1. The sales price less the adjusted basis of the structure (without taking depreciation into account).  This is taxed at the capital gains tax rate, which is 15% for assets held one year or more;
2. Depreciation must be recaptured to the extent that a profit was made on the transaction.  Depreciation recaptured is taxed at a special capital gains rate of 25% (this is still advantageous since the depreciation was deducted at ordinary rates, which can go as high as 35%)

Many people make the mistake of foregoing the depreciation deduction on their rental property or home office, thinking that this also relieves them of the need to calculate depreciation recapture tax.  Unfortunately, this is not true.  Depreciation claimed or that could have been claimed must have recapture tax paid.

Let's take a common example.  John pays $330,000 for a rental property.  He gets bad or no tax advice, and fails to claim depreciation.  Two years later, he sells it for $500,000.  John thinks he has a capital gain of $170,000, and he is correct.  He will pay 15% of that in capital gains tax, or $25,500.

What John doesn't realize is he also must pay recapture tax on the depreciation he never claimed.  He failed to claim $24,000 in depreciation, and must pay a recapture tax of $6000 on this.  That's pretty steep.

What's John to do?  If he first placed the asset in service three years ago or less, he should amend his returns to reflect proper depreciation.  If the asset is older than that, he may have to apply for a change in accounting method in order to reflect the full depreciation deduction in the year of sale.

Either way, John (and his tax preparer) are in for some needless work that could have been avoided if John had claimed his depreciation all along. 

Comments

[D Bluthenthal]

Tax Playa, thanx for your awesome site. I have a question due to not claiming home office depreciation in 2005. Having unwisely skipped it last year, I'd now like to submit a 1040X and claim it for 2005. However, I also have a SEP IRA into which I paid a maximum allowable amount last year, so when I take the home office depreciation, it will lower my maximum allowed for a SEP contribution. What will happen to the excess money I will have contributed? Can it be carried over to this tax year's contribution? Must I pay an excise tax? I also have a Roth that was not maxed out last year. Can it be transferred? We're talking about $500-$1000.What should I do?

[Wayne Powell]

In reading an article at http://realtytimes.com/rtcpages/20070219_capitalgains.htm which states in part "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 julianblocktaxexpert.com)"

This appears to be one way to avoid the 25% recapture tax even though the taxpayer would still be subject to a capital gains tax. Do you agree?

[Ryan Ellis]

I wish it were that simple (just to say that depreciation was never deducted). However, the tax code clearly states that all depreciation claimed OR THAT COULD HAVE BEEN CLAIMED must be recaptured upon sale with a gain.

[juan brasofuerte]

I have rental property that I have never lived in. If I move in with the wife for two years, then I get a $500K exclusion on the captial gain tax. Would I still owe the 25% recapture on the depreciation taken when I rented the property and it was not my primary residence.

[Sean Goss]

Depreciation, book or tax, and the variances are confusing the hell out of people.
A proper fixed assets register, with proper depreciation calculations, and a seperate schedule for tax depreciation should always be drawn up, and not confused with each other.