Rental Real Estate Question: Repair Expenses or Depreciation, Capital Gain Exclusion or Taxable Income | USTaxAid

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Rental Real Estate Question: Repair Expenses or Depreciation, Capital Gain Exclusion or Taxable Income

Written by Diane Kennedy, CPA on November 18, 2022

Today’s tax question showed up at USTaxAid after the extended due date for 2021 returns. My first thought is good for the writer! Too many people get concerned that their return is late and then don’t file. The year goes by and it’s time for another filing. And they put it off. Before you know it, they are years without filing and suddenly the IRS and a state or two are after them, stripping out bank accounts to zero in the dead of night.

So, I’m happy when I see someone who is doing what it takes to get a return filed, even if it is late.

There are actually two questions, which I have edited:

  • I spent $11,000 in repairs and did updates worth $20,000 in 2021 on a rental property. If I capitalize them and depreciate, the IRS will make me recapture depreciation and pay tax on it. Do I have to depreciate?

Let’s start with that one. The IRS does require you to capitalize some expenses and then depreciate them. The easiest way to turn an asset into a repair expense is to qualify for one of the exceptions. For example, if you have an invoice that is under $2,500, you can expense that item.

Otherwise, you are pretty much stuck capitalizing improvements. The depreciation then has to be recaptured and is taxed if you sell at a gain.

How to Write Off Improvements to Your Rental Property

Is it true that, in the 2 of 5-year residence rule that allows $250,000 deduction off of taxable basis, that the IRS rule is that you can only take the # of years you lived in it divided by the # of years owned and only get the portion of the $250,000 that can be deducted. For example, say you lived in the 2 and owned it for 10, So, you would only get 20% (2/10) of the $250,000 that can be deducted from your tax basis vs the $250,000, which would equate to $50,000 off of your adjusted tax basis.

Kind of. It’s applicable for years starting 2009. The 5-year period is the 5 years previous to the sale date. If the property was rented first, then you have to prorate the gain (not prorate the capital gain exclusion). If you first lived in the house and then rented it out, you do not need to prorate.

So, using this example, let’s say that you rented it for 8 years and then lived in it as a primary residence for 2 years. You had $200,000 worth of gain in that 10-year period. A portion of it, 8/10 * $200,000 ($160,000) is taxable. A portion of it 2/10*$200,000 ($40,000) is nontaxable.

Now let’s say you lived in it for 2 years and then rented it for 8. If you go back 5 years, it’s been a rental. There is no capital gain exclusion.

If you lived in it for 3 years and rented it for 2, the entire capital gain exclusion would apply.

Real estate tax can be complicated. Make sure you’re working with the most current tax information when you make important decisions.

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