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Retired Military Finances 201: Understanding Depreciation Recapture

Taxes Retirement Funding

Military Careers Often Equal Owning Rental Property

If you've hung around the military for 20 plus years there is a pretty good chance that you acquired some rental property. I know that I picked up a couple and many of our clients have one or two as well.

Rental property can be a good investment. It is also very complicated from a tax standpoint. Most that complication comes from the fact that rental property needs to be depreciated.

Depreciation Accounts for Items Wearing Out

When you operate a business, like renting real estate, you can generally deduct the expenses associated in running the business as long as they are ordinary and reasonable. I like to say, "If you're spending a buck to make a buck, you can deduct it." This is true for things that you consume. Paper might be one example. Mileage to check on the property might be another. Fees you pay to a property manager are also expenses that can be deducted.

But what about the property itself? Purchasing the property is an expense of the business and it would follow that you can deduct it. In a way you can. But, instead of deducting it in a single year you must capitalize it over the life of the property. In other words, since the house isn't going be be consumed in a year, you need to deduct a portion of the cost each year you own the property until you've accounted for the money spent on buying it (for the structure only, land isn't depreciated). In the case of the rental residential property, the life of the property is set by the IRS at 27.5 years.

But There is a Rub

When you depreciate property you're saying that each year it is worth less and less. A classic example of this is a car. We all instinctively know that a car becomes less and less valuable each year we own it. So if we had a car exclusively used for business, when we sell it, it is likely that the depreciated value and the fair market value (what we can sell it for) will at least be close.

This isn't the case with real estate. In most cases (but not all...I moved to Northern Virginia in 2005) real estate goes up in value over time. When we sell a rental house for more than its depreciated value (called adjusted basis) the IRS says, "Wait a minute! You lied to us. You said the house was going down in value and it went up. We want those deductions we gave you for depreciation back." And while you didn't really lie, the concept is valid. You sold the house for more than it is "worth" so you have a gain. Technically this is called a 1250 gain. Many people call it depreciation recapture. Let's look at an example. For simplicity, I'll leave out improvements or other costs associated with buying or selling the property.

Purchase Price (Basis)
$500,000
Depreciation
$25,000
Adjusted Basis
$475,000
Sale Price
$550,000
1250 Gains (Basis minus Adjusted Basis)
$25,000
"Ordinary" Capital Gains (Sale Price - Basis)
$50,000


1250 Gains are taxed at a maximum rate of 25%.  The other capital gains are taxed at a preferred rate which will be 15% for most taxpayers. If you can qualify the property as your primary residence you might be able to avoid the tax on these gains but not the 1250 gains.

It is also worth noting that if the property sells for the for less than the original basis, then the difference between the selling price and the adjusted basis will be 1250 gain.

Don't Be Too Smart for Yourself

If you've made to senior military ranks you're no dummy. That doesn't mean you should try to outsmart the tax code. I've run into more than one retiring military officer who has told me that he or she decided to not take depreciation so as to not have this issue. Sorry. The tax code says that when you sell the property you must pay taxes on  the depreciation allowed or allowable. In other words, even if you didn't claim depreciation you will still likely owe taxes on1250 gains.

There is a solution. If you failed to take depreciation you can file with the IRS for a change in accounting systems. This is due to the fact that if you are not depreciating your property you are using an unauthorized accounting system. To do this, you file IRS Form 3115. To be honest, you're probably going to need help with this one and need a tax preparer who knows how to do them. If properly filed, the 3115, will take care of the issue and will offset a lot of the gain from the sale.

Military Members Can Have Complicated Taxes

The Tax Code is littered with special tax rules for military members. It is more than a little challenging to keep up with them all. If you think you'd like some help, give us a call.


If you liked this article, you might enjoy the following blog posts:

Retired Military Finances 201: 1031 Exchanges


Military Finances 101: Becoming a Landlord


Military Landlord? You Have Estate Planning Issues



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