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This is my 1st posting… I have acquired a few rental properties in the past 3 years. Due to the depreciation deduction on the tax return, I have always been able to take the max $25,000 passive activity loss with sever years’ worth of carry over. I wondered if I could skip claiming the depreciation expense on my rental properties so that I would not have to recapture it at the time when I sell the rental property. After some research, I found 2 answers: 1: at the time of the sale of the rental properties, I have to reduce my purchase price with all the rental depreciation REGARDLESS if I actually claimed them or not on my tax return over the years I am renting them out; 2: I only need to recapture the depreciation I ACTUALLY TOOK. Can any authority here give me an affirmative answer? It seems to me unfair that I have to recapture all the depreciation regardless if I took them or not. However, if that’s true, how do I plan ahead to minimize this recapture tax? By the way, I do not have other “passive activities”, which means that all those rental activities carry-over loss is wasted each year. Is there a way to use this loss offset the gain at the time when I sell my rental properties?
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Depreciation is recaptured whether you took the deductions or not...the IRS assumes you depreciated your property correctly so there is no benefit from not claiming depreciation.
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Incidentally, would it be possible to become an active participant in your rental properties? How many units do you have? The amount of work necessary to become an active participant isn't that much. I assume you are using a mangement company. If you can arrange for them to consult with you on new tenants, changes in lease terms, repairs, and you would be considered an active participant. You should also have them send you the revenue and pay the mortgages yourself.
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Sorry, I just realized the $25k lost limit assumes you are an active participant. I had forgotten about that, I'm not approaching that much in losses myself unfortunately!
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Just keep depreciating the properties. When you sell, the accumulated losses on the property sold become allowable without regard to the $25k annual limit. So you get the benefit in that year.

And that can work to your advantage. You get to write off the deferred losses as ordinary income. That saves you taxes at your marginal rate. But the capital gain due to the depreciation taken is limited to 25%. So if you're in the 28% or higher bracket, you come out ahead. Even if you're not in a higher bracket, you still come out even.

Further, if you have a capital gain because of the sale, that could allow some of the deferred losses from the other properties to be released and used. The capital gain is part of your passive activity income. So the deferred passive activity losses can be used to offset that income. And you again have the chance for some tax rate arbitrage here. The capital gain portion is currently taxed at a rate less than your ordinary losses from the passive activities. So you get to recognize capital gains and ordinary losses. The best of both worlds.

IOW - don't try to fight the system. It's not a bad system at all. You just don't get to have it all right away.

--Peter
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Peter, this is the best explanation so far I have ever researched and found on this subject. I understood 97% of your reply, except your sentence at the end: "The capital gain portion is currently taxed at a rate less than your ordinary losses from the passive activities". Can you elaborate a bit or give an example?
Jo
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Peter, this is the best explanation so far I have ever researched and found on this subject.

Thank you. There must be better ones out there. Just keep looking.

I understood 97% of your reply,

Wow! I only understood 75% of what I wrote. ;-)

except your sentence at the end: "The capital gain portion is currently taxed at a rate less than your ordinary losses from the passive activities". Can you elaborate a bit or give an example?

Sure.

No matter what your tax bracket, long term capital gains are taxed at a lower rate than ordinary income. (Well, unless you have so little income that you are effectively in the zero percent bracket.) The passive losses you are accumulating - the amounts in excess of $25k per year - are almost certainly ordinary income. When you use them, they reduce your ordinary income and save you tax dollars at your marginal rate.

Long term capital gains are taxed at no more than 15%. The long term capital gains from selling a rental property (assuming that you hold these long enough to actually have a gain on the properties) get this beneficial tax rate. AND that long term capital gain also allows you to use a portion of the deferred passive losses.

So you reduce your ordinary income at the same time you recognize long term capital gain income. If the amounts happened to be equal, that means more of your total income will be taxed at the lower capital gain rate.

Granted, from an overall perspective it would be nice to use those losses now rather than later. But since the tax law prohibits that, you still get to use them, even if it is some time down the road. And when those losses are finally freed up, they're going to help improve your overall tax rate in the year you do get to use them.

So, like I said earlier, just take the depreciation now, accumulate up the losses, and you'll put them to use down the road when you finally sell. When you do that, you'll be better off than you would have been had you not depreciated the property at all.

--Peter
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