What is Recapture of Depreciation

What is Recapture of Depreciation

The What is Recapture of Depreciation As we saw in the previous example, it is possible to convert investment property to a primary residence. That example was, however,
uncharacteristically perfect because the facts left no doubt that the taxpayers could increase the fair market value while at the same time decreasing the tax liability. The facts also stated that the property had been fully depreciated since 1995.

In the real world, there is seldom such a large upside potential, and the property is usually still being depreciated. This complicates the issue because even though the primary residence exemption may apply, it will not shield that portion of the gain equal to the depreciation taken on the property after May 6, 1997 (the effective date of the Taxpayer Relief Act).

Example:
In 1996 Joe bought a rental condominium in California for $200,000, which he is considering selling in 2003 and looking at the tax issue. The current market value of the property is $300,000, and the current adjusted basis is approximately $155,000. Joe knows the capital gains tax on the sale is going to be approximately $44,200 if he sells it outright. The idea of writing a check to the IRS for that amount does not sit well with Joe, so he is trying to decide if it would be worthwhile to move into the property for two years to obtain the primary residence exemption. After doing the math, Joe realizes that he has taken approximately $45,000 in depreciation since May 6, 1997; and he knows none of that depreciation will be shielded by the primary residence exclusion. That means that even if he does move into the property for two years to qualify for the exclusion, he will still have to write a tax check for approximately $15,300.

If Joe is like most people, he is going to forgo trying to convert the property to a primary residence and instead will look for other alternatives. For most people, moving to a property for two years just to save on taxes is simply too disruptive of their lifestyle to actually do more than merely consider the option. However, it is nice to know that if the tax savings are high enough or the right situation presents itself, the option is available.