Is renting a place out worth it considering the Depreciation Recapture Tax?

[Anonymous]

So we have enough saved up that we could buy a place without selling our present one. (Yea, us!) We would see a pretty big net profit every month if we rented our present place out, so we feel like we should at least explore the options, despite our misgivings about being landlords! (We have heard horror stories. We aren't taking this lightly. But that is a story for another thread.) Anyway. What I want to ask about is this little bugger called, "depreciation recapture tax." Am I right that if we eventually sold our could-be rental, we'd pay a 25% tax rate on the (yearly depreciation we've claimed x the property's asset life span?) plus the overall capital gains tax? And both of those amounts would come out of the sale profit? Ouuuuchhh.... Uncle Sam do take a bite, as my husband says. Then why do so many people rent out their places?

[Anonymous]

Anonymous wrote:So we have enough saved up that we could buy a place without selling our present one. (Yea, us!) We would see a pretty big net profit every month if we rented our present place out, so we feel like we should at least explore the options, despite our misgivings about being landlords! (We have heard horror stories. We aren't taking this lightly. But that is a story for another thread.) Anyway. What I want to ask about is this little bugger called, "depreciation recapture tax." Am I right that if we eventually sold our could-be rental, we'd pay a 25% tax rate on the (yearly depreciation we've claimed x the property's asset life span?) plus the overall capital gains tax? And both of those amounts would come out of the sale profit? Ouuuuchhh.... Uncle Sam do take a bite, as my husband says. Then why do so many people rent out their places?

underwater

[Anonymous]

Why I would you let a tax stop you from making money?

[Anonymous]

haha! Good point. I was wrong about the equation up there. It's 25% tax rate on (yearly depreciation we've claimed x years of ownership.)

[Anonymous]

22:20--- because the amount we'd lose in taxes at time of sale could surpass the amount we'd net in rent if we aren't careful. It'd take several years to just break even on the depreciation recapture tax, which keeps going up with every year of ownership. Ruh roh.

[Anonymous]

Anonymous wrote:Why I would you let a tax stop you from making money?

For some reason, I think this is a serious question, so I'll answer it. How about because the tax does stop you from making money? You realize that the tax is money that would otherwise be in your pocket, and there is such a thing a "opportunity cost?" If Uncle Sam wants to take away profit from one activity, I'll go find something else to do with my capital, thank you very much.

We considered keeping our old house and renting it out, but after we calculated the tax consequences, we quickly realized that it was a lose/lose. At least you're in a position to make a profit. Those who can only rent at loss get a double whammy. Unless you're a "real estate professional" you can't deduct losses from your other income, and, when you sell, you must deduct depreciation from your basis, even if you weren't able to actually get the benefit of the depreciation while you were renting. If you're underwater and can't rent for more than your mortgage, if you can do it at all, you're better off taking the financial hit up front, than doing a slow bleed by renting at a loss. Not to mention if you trigger AMT, which you probably will if you're trying to deduct interest from your current home as well as the costs of the rental, in which case you effectively won't be able to use any of the deductions, anyway.

Particularly with all of the hassles of renting, I don't know why anyone does it unless they bought the property in 1965 for nothing and very little in the way of expenses and no basis to start with.

[Anonymous]

Well, that explains it. Bought on the hill in 1996. Two units, blocks from the Capitol, paid $141K. Paid off the mortgage. Rents for about $4K now.

It's worth it.

[Anonymous]

OP here, and yes, 22:40, I feel you. The balance on our present mortgage is blessedly small, in the low five digits. We are nowhere near to being underwater. So we would realize a tidy sum every month, given how rents are (too damn) high. Still, it would take several years to break even with taxes, and that depreciation recapture tax goes up with every year of ownership. BTW, we are talking to an *actual financial professional* about this, but I wanted to know what all the common folk of DCUM thought, too.

[Anonymous]

Also, 22:40, what do you mean when you use the word, 'basis?'

[Anonymous]

hmmm... never heard of any of this. I will be interested in responses. Does the outcome depend on how much you owe, and how much is the mortgage you are covering, vs. how much you can get in rent? (I smell an Excel spreadsheet coming on.)

[Anonymous]

Anonymous wrote:Also, 22:40, what do you mean when you use the word, 'basis?'

Your "basis" is the amount of your investment, and is used to calculate your profit. If the property is an investment property, you can deduct depreciation as an expense, but it reduces the amount of your basis. So if you paid $100,000 for the house, and you've deducted $50,000 in depreciation from income from the property over the years, your basis is $50,000 (assuming you haven't invested in any improvements to the property). If you sell it for $200,000, you pay capitol gains tax (assuming the investment otherwise qualifies) on $150,000 in profit. The real bummer on rental property is that, even if you haven't made a profit against which you can deduct the depreciation, you still have to lower the basis to reflect depreciation, so you owe more in tax when you sell. On the house you have as your residence, your basis is what you paid, plus the value of any improvements you've added over the years, on top of which you get to exclude $500,000 -- last time I checked -- in profit from tax altogether. I understand why they are promoting home ownership, but I don't understand why they want to actively discourage renting.

[Anonymous]

Anonymous wrote:

Anonymous wrote:Also, 22:40, what do you mean when you use the word, 'basis?'

Your "basis" is the amount of your investment, and is used to calculate your profit. If the property is an investment property, you can deduct depreciation as an expense, but it reduces the amount of your basis. So if you paid $100,000 for the house, and you've deducted $50,000 in depreciation from income from the property over the years, your basis is $50,000 (assuming you haven't invested in any improvements to the property). If you sell it for $200,000, you pay capitol gains tax (assuming the investment otherwise qualifies) on $150,000 in profit. The real bummer on rental property is that, even if you haven't made a profit against which you can deduct the depreciation, you still have to lower the basis to reflect depreciation, so you owe more in tax when you sell. On the house you have as your residence, your basis is what you paid, plus the value of any improvements you've added over the years, on top of which you get to exclude $500,000 -- last time I checked -- in profit from tax altogether. I understand why they are promoting home ownership, but I don't understand why they want to actively discourage renting.

Sorry -- before the spelling police get me -- that's "capital gains tax."

[Anonymous]

Anonymous wrote:So we have enough saved up that we could buy a place without selling our present one. (Yea, us!) We would see a pretty big net profit every month if we rented our present place out, so we feel like we should at least explore the options, despite our misgivings about being landlords! (We have heard horror stories. We aren't taking this lightly. But that is a story for another thread.) Anyway. What I want to ask about is this little bugger called, "depreciation recapture tax." Am I right that if we eventually sold our could-be rental, we'd pay a 25% tax rate on the (yearly depreciation we've claimed x the property's asset life span?) plus the overall capital gains tax? And both of those amounts would come out of the sale profit? Ouuuuchhh.... Uncle Sam do take a bite, as my husband says. Then why do so many people rent out their places?

Well, that recapture tax merely offsets a small portion of the tax savings you realized while you owned the property, so it's not really a TAX.

As for the capital gains tax, well, you could also move back into it for a couple of years and exempt the first $500,000 or so. Otherwise, the capital gains tax is 20% (unless you're very high income).

[Anonymous]

Anonymous wrote:

Anonymous wrote:Also, 22:40, what do you mean when you use the word, 'basis?'

Your "basis" is the amount of your investment, and is used to calculate your profit. If the property is an investment property, you can deduct depreciation as an expense, but it reduces the amount of your basis. So if you paid $100,000 for the house, and you've deducted $50,000 in depreciation from income from the property over the years, your basis is $50,000 (assuming you haven't invested in any improvements to the property). If you sell it for $200,000, you pay capitol gains tax (assuming the investment otherwise qualifies) on $150,000 in profit. The real bummer on rental property is that, even if you haven't made a profit against which you can deduct the depreciation, you still have to lower the basis to reflect depreciation, so you owe more in tax when you sell. On the house you have as your residence, your basis is what you paid, plus the value of any improvements you've added over the years, on top of which you get to exclude $500,000 -- last time I checked -- in profit from tax altogether. I understand why they are promoting home ownership, but I don't understand why they want to actively discourage renting.

What you describe above isn't even technically accurate. Your inability to spell "capital" in "capital gains" is the first clue.

Depreciation doesn't lower your basis, unless you're making an argument that this is the economic effect of the recapture tax. You're also only counting one side of the equation and conveniently omitting the tax SAVINGS the depreciation provides during the years you own the asset.

You seem to want your cake and to eat it too.

[Anonymous]

SO... if we have very little left on the mortgage, and we can get a LOT in rent, is it worth it? Or does the depreciation recapture negate the profit? We can also make a lot if we sell, so we don't wanna screw this up.