For military members, moving every couple years can be a double-edged sword. On one hand, it’s tough uprooting your whole family. On the other, it gives you an opportunity to build a portfolio of investment properties, especially considering the tremendous benefits of the VA Home Loan program.
However, as military members transition a property from their primary residence to a rental, it’s critical that they understand the tax implications of such a move. Specifically, people need to understand how depreciation on rental properties works and, more importantly, how the IRS practice of collecting depreciation recapture taxes affects landlords.
Understanding – and planning for – depreciation recapture as a landlord will save you a nasty tax surprise when you sell an investment property!
In the following article, we’ll outline the following to help you understand this important investing topic:
- IRS residence classifications – primary vs. investment
- Depreciation – a definition
- When does depreciation begin?
- Depreciation recapture taxes on rental properties
- A comprehensive example for a military family
- Final thoughts
Veterans Can Buy a Home with $0 Down
{Sponsored} The VA Home Loan offers $0 Down with no PMI. Find out if you’re eligible for this powerful home buying benefit. Prequalify today!
IRS Residence Classifications – Principal vs. Investment
While the terms primary, principal, rental, and investment all get thrown around among property owners, it’s important to understand that the IRS has specific definitions – and tax treatments – for different residence types.
- Principal (a.k.a. primary) residence: This is your actual home, that is, the place where you live for the majority of the year. The IRS provides certain tax benefits (capital gains exclusions, mortgage interest deduction, etc) associated with these properties.
- Investment (a.k.a. rental) property: This is an income-producing property, that is, the homeowner acts as a landlord and rents the property to tenants. Income and expenses related to these properties are treated like business expenses and reportable on a taxpayer’s Schedule E.
For the purpose of this article, the most important difference between the above two property types is that an investment property is depreciated, whereas a principal residence is not. This begs the question, what, exactly, is depreciation?
Depreciation – a Definition
Prior to discussing depreciation recapture, it’s necessary to first define depreciation, itself. This is a strange concept for first-time landlords without accounting backgrounds, as taxpayers do not depreciate their principal residences.
It helps to first think of necessary business expenses. If you own a business, you likely need to rent office space. The amount you pay to rent that office is tax deductible as a necessary business expense.
As a landlord, your property is the largest business expense you’re likely going to make. But, the IRS wants to get paid, so you’re not allowed to buy a $200,000 rental property and reduce your tax bill by $200,000 in the year of purchase (though that would certainly be nice!).
Instead, the process of depreciation exists. According to the IRS, “Depreciation is the recovery of the cost of the property over a number of years. You deduct a part of the cost every year until you fully recover its cost.”
Basically, the IRS knows that the income provided by a rental property will be spread over multiple years. As such, the process of depreciation spreads – or “matches” – the associated tax-deductible expense over an extended period during which the property is generating rental income (27.5 years for residential real estate).
For military landlords, this means that every year, you can reduce your tax bill by deducting the annual depreciation allowed from the rental income received for that property.
NOTE: Land is not depreciable; only the building on the land is. So, if you buy a home for $200,000, to figure how much can be depreciated, you need to look at the property tax record.
If the property is assessed for tax purposes for $150,000 ($100,000 for the house and $50,000 for the land), the landlord’s depreciable base is the purchase value ($200,000) times the ratio of the house value over the total tax assessed value ($100,000/$150,000), for a total of $133,333 (more on this in the below comprehensive example).
When Does Depreciation Begin?
Now that we’ve defined depreciation, military landlords need to understand when it begins. Specifically, if a military family uses the VA Home Loan to buy a principal residence, then moves and rents their home out, when do they start depreciating the property?
This is a key point for military landlords to understand – depreciation begins when an investment property is placed in service, not purchased.
So, for the period when the family from this example is living in their home as a primary residence, they do not depreciate the property. However, when they move out and place it in service as a rental property (that is, begin marketing it for rent), they begin the depreciation process in the middle of that month.
For tax purposes, if you began marketing your property for rent in October, you would be able to claim 2 ½ months of depreciation (half of October, all of November, and all of December).
Depreciation Recapture Taxes on Rental Properties
Now we can finally tackle the big questions: what is depreciation recapture, and how does it affect taxpayers when they sell an investment property?
As the saying goes, the IRS giveth, and the IRS taketh away. Due to the fact that depreciation reduces a landlord’s taxable income every year, the IRS wants to eventually claw back that money, and it does so through something called depreciation recapture taxes, which are taxes paid in addition to capital gains taxes.
Here’s a basic example (ignoring transaction costs like realtor commissions):
- John purchased a home in 2015 for $200,000.
- From 2015 through 2020, he depreciated $30,000 for a new tax basis of $170,000 (we assume $30,000 was the IRS-allowable amount for the sake of this example)
- In 2020, John sold the home for $250,000
- Tax results:
- $50,000 ($250,000 sales price minus $200,000 purchase price) in capital gains taxed at either 0%, 15%, or 20% tax rates
- $30,000 ($200,000 purchase price minus $170,000 post-depreciation tax basis) in depreciation recapture taxed at a flat rate of 25%
What this means is that, if Bob didn’t understand depreciation recapture, he would think that he was only going to receive a tax bill for the property sale of $7,500 ($50,000 gain times 15% capital gains rate). But, he’s also on the hook for a depreciation recapture bill of another $7,500 ($30,000 in allowed depreciation times 25%)!
So, by not understanding depreciation recapture, Bob would have underestimated his tax liability by half, thinking he owed $7,500 instead of $15,000.
And, if that’s not bad enough, the IRS is going to charge Bob that depreciation recapture tax regardless of whether he actually recorded depreciation on his tax returns for the time he rented his property, so make sure you depreciate every year!
A Comprehensive Example for a Military Family
Depreciation and depreciation recapture can be pretty daunting topics for new landlords, but they don’t need to be. The following is a comprehensive example that ties all of the above together for a military family.
- In 2010, Captain Smith and his wife used the VA Home Loan to purchase their home in San Antonio. The couple lived in this home through the end of 2013, and then they were transferred to California. Instead of selling the house, they decided to turn it into an investment property and rent it out.
- They purchased the home in 2010 for $300,000, and the tax assessment valued it at $250,000 ($200,000 for the house and $50,000 for the land).
- Depreciable base: $300,000 x ($200,000 / $250,000) = $240,000
- Annual IRS-allowed depreciation: $240,000 / 27.5 years = $8,727/year
- From January 2014 through December 2019, Captain Smith and his wife rented their property, depreciating the allowable amount of $8,727 each year (this means that if they received $20,000 in rental income each year, they’d be able to reduce the taxable amount with depreciation by $8,727 each year).
- At the end of 2019, their taxable basis in their rental property now was $247,638 ($300,000 purchase price – $8,727/year x 6 years).
- In January 2020, they sold their rental property for $350,000, and here are the taxes they needed to pay:
- Capital gains: $50,000* x 15% = $7,500
- (*$350,000 sale price minus $300,000 purchase price)
- Depreciation recapture: $52,362* x 25% = $13,091
- (*$300,000 purchase price minus $247,638 taxable basis at sale)
- Capital gains: $50,000* x 15% = $7,500
So, without considering depreciation recapture, Captain Smith and his wife would’ve only planned on $7,500 in taxes related to their investment property sale. But, with depreciation recapture, their total tax bill was $20,591!
Final Thoughts
While you can’t avoid depreciation capture when you sell a property, planning for it will save you from a nasty tax surprise when you sell your investment property.
And, for military investors looking to continue building their rental real estate portfolios after the sale of one property, using a 1031 exchange is a technique to defer paying the depreciation recapture tax.
Maurice “Chipp” Naylon spent nine years as an infantry officer in the Marine Corps. He is currently a licensed CPA specializing in real estate development and accounting.
Chapter Two of the handbook addresses issues related to VA loan entitlement and reusing that entitlement to buy another property.
To begin, it’s important to define terms–what does the Department of Veterans Affairs define as a condominium unit?
The rules for these programs vary by state and depending on location there may be income limits, caps on sale prices, and some may be specifically need-based.
The most important question to ask yourself for any of these purchases? That depends on your circumstances but if you are an active duty service member subject to deployments, TDY, continuing education, or are in a career field that requires a great deal of travel your priorities are obviously different than someone who has retired after a 20-year career in uniform or more.