Author: Leon Clinton

Tax

Depreciating Residential Rental and Commercial Real Property

When you own rental property, depreciation is your best friend. 

One reason depreciation is so valuable is that, unlike deductible rental property expenses such as interest and maintenance, you get to claim depreciation year after year without having to pay anything beyond your original investment in the property. 

Moreover, rental real property owners are entitled to depreciation even if their property goes up in value over time (as it usually does).

The basic idea behind depreciation is simple, but applying it in practice can be complex. Indeed, the annual depreciation deductions for two properties that cost the same can be very different.

For example, if you own a motel with a depreciable basis of $1 million, you get to deduct $25,640 each year for depreciation (except the first and last years). If you own an apartment building with a $1 million basis, your depreciation deduction is $36,360. 

Why the difference? A motel and apartment building are both rental real estate. Shouldn’t they be depreciated the same way? Not according to the tax law. An apartment building is a residential rental property, while a motel is a commercial rental property. There are different depreciation periods for commercial and residential property: it takes far longer to depreciate commercial property fully.

For this reason, you should always make sure you correctly classify your property as commercial or residential. Such classification can be more challenging than you might think, especially for mixed-use property. If you rent to residential and commercial tenants, the tax code classifies the building as residential only if 80 percent or more of the gross annual rent is from renting dwelling units. 

Even properties rented only for residential use may have to be classified as commercial if a majority of the tenants or guests are transients who stay only a short time. This rule can adversely impact the depreciation deductions for property owners who rent their property to short-term guests through Airbnb and other short-term rental platforms.

If you’ve been using the wrong depreciation period for your residential or commercial rental property, you should correct the error by filing an amended return or IRS Form 3115 to fix depreciation errors more than two years old.

If you have any questions or need my assistance, please call me on my direct line at 408-778-9651.

Tax

Self-Directed IRAs – Are They for You?

Tax-advantaged retirement accounts such as IRAs are a great way to save for retirement. 

But when you establish a traditional IRA with a bank, a brokerage, or a trust company, you are ordinarily limited to a narrow range of investment options, such as CDs, publicly traded stocks, bonds, mutual funds, and ETFs. The IRA custodian will not permit you to invest in alternative investments such as real estate, precious metals, or cryptocurrency.

A self-directed IRA could be for you if you want to walk on the wild side and invest your retirement money in assets such as real estate or cryptocurrency.

You can invest in almost anything other than collectibles such as art or rare coins, life insurance, or S corporation stock with a self-directed IRA. Investment options include, but are not limited to the following:

  • Real estate
  • Private businesses
  • Trust deeds and mortgages
  • Tax liens
  • Precious metals such as gold, silver, or platinum
  • Private offerings
  • LLCs and limited partnerships
  • REITs
  • Livestock
  • Oil and gas interests
  • Franchises
  • Hedge funds
  • Cryptocurrency
  • Promissory notes

Aside from he vast array of investment options, a self-directed IRA is the same as a traditional IRA and subject to the same rules. The income the investments in your IRA earn is not taxed until you take distributions, but distributions before age 59 1/2 are subject to a 10 percent penalty unless an exception applies. 

You can also have a self-directed Roth IRA for which distributions are tax-free after five years.

But you must avoid self-dealing and other prohibited transactions or your self-directed IRA could lose its tax-advantaged status.

Establishing a self-directed IRA need not be too difficult. You first open an account with a custodian that offers self-directed investments. You can also acquire checkbook control over your self-directed IRA by forming a limited liability company to own all the IRA investments.

Investing in alternative assets such as cryptocurrency is riskier than stocks, bonds, and mutual funds. 

  • The rewards can be great, as you’ve seen with recent returns for cryptocurrency investors. 
  • And the damage to your investment portfolio can be substantial, as we’ve also seen over the years.

When it comes to alternative investments, you need to know what you are doing or have an investment professional you trust to do this for you.

If you have any questions or need my assistance, please call me on my direct line at 408-778-9651.

Tax

Little-Known Rule Can Reduce Your Principal Residence Tax Break

Once upon a time, you could convert a rental property or vacation home into your principal residence, occupy it for at least two years, sell it, and take full advantage of the home sale gain exclusion privilege of $250,000 for unmarried individuals or $500,000 for married joint-filing couples. 

Unfortunately, legislation enacted back in 2008 included an unfavorable provision for sales that occur after that year. The provision can make a portion of your gain from selling an affected residence ineligible for the gain exclusion privilege. 

The Non-Excludible Gain

Let’s call the amount of gain that is made ineligible the non-excludable gain. The non-excludable gain amount is calculated as follows. 

Step 1. Take the total gain and subtract any gain from depreciation deductions claimed against the property for periods after May 6, 1997. Include the gain from depreciation (so-called unrecaptured Section 1250 gain) in your taxable income. Carry the remaining gain to Step 3.

Step 2. Calculate the non-excludable gain fraction. 

The numerator of the fraction is the amount of time after 2008 during which the property is not used as your principal residence. These times are called periods of non-qualified use. 

But periods of non-qualified use don’t include temporary absences that aggregate to two years or less due to changes of employment, health conditions, or other circumstances specified in IRS guidance. 

Periods of non-qualified use also don’t include times when the property is not used as your principal residence if those times are

  • after the last day of use as your principal residence, and
  • within the five-year period ending on the sale date. (See Example 4 below.) 

The denominator of the fraction is your total ownership period for the property.

Step 3. Calculate the non-excludable gain by multiplying the gain from Step 1 by the non-excludable gain fraction from Step 2. 

Step 4. Report on Schedule D of Form 1040 the non-excludable gain calculated in Step 3. Also report any unrecaptured Section 1250 gain from depreciation for periods after May 6, 1997, from Step 1. The remaining gain is eligible for the gain exclusion privilege, assuming you meet the timing requirements. 

Some Examples

Overly complicated federal income tax rules create a lot of taxpayer confusion, so let’s consider the following examples that illustrate how to calculate non-excludable gains from principal residence sales.  

Example 1. Dan, a married joint-filer, bought a rental property on January 1, 2001. On January 1, 2016, he converted the property into his principal residence and lived there with his spouse from 2016 through 2021. 
On January 1, 2022, Dan sells the property for a $600,000 gain, including $50,000 of depreciation deductions claimed for the 15-year rental period (January 1, 2001, to December 31, 2015). 
Dan must report the $50,000 of gain attributable to depreciation deductions—the unrecaptured Section 1250 gain—on his 2021 federal return. That gain is subject to a maximum federal rate of 25 percent, plus another 3.8 percent if the gain is hit with the NIIT.   
Dan’s remaining gain is $550,000 ($600,000 – $50,000). 
Dan’s total ownership period is 21 years (2001-2021). The seven years of post-2008 use as a rental property (2009-2015) result in a non-excludable gain of $183,333 (7/21 x $550,000). Dan must report the $183,333 as a long-term capital gain on his 2021 Schedule D. 
He can shelter the remaining $366,667 of gain ($550,000 – $183,333) with his $500,000 gain exclusion.
Example 2. Claudia, a married joint-filer, bought a vacation home on January 1, 2013. 
On January 1, 2017, she converted the property into her principal residence, and she and her spouse lived there from 2017 through 2021. 
On January 1, 2022, Claudia sells the property for a $600,000 gain. Her total ownership period is nine years (2013-2021). 
The four years of post-2008 use as a vacation home (2013-2016) result in a non-excludable gain of $266,667 (4/9 x $600,000). Claudia must report the $266,667 as a long-term capital gain on her 2022 Schedule D. 
She can shelter the remaining $333,333 of gain ($600,000 – $266,667) with her $500,000 gain exclusion.      
Example 3. Same basic facts as in the preceding example, except this time assume that Claudia has $10,000 of unrecaptured Section 1250 gain from renting out the property before converting it into her principal residence. 
Therefore, the total gain on the sale is $610,000. Claudia must report the $10,000 of unrecaptured Section 1250 gain on her 2022 Schedule D. 
She must also report the non-excludable gain of $266,667 [4/9 x ($610,000 – $10,000)] on her 2022 Schedule D. 
She can shelter the remaining $333,333 of gain ($610,000 – $10,000 – $266,667) with her $500,000 gain exclusion.      
Example 4. Gary is a married joint-filer. He bought a vacation home on January 1, 2013. On January 1, 2016, he converted the property into his principal residence and lived there with his spouse from 2016 through 2019. 
He then converted the home back into a vacation property and used it as such for 2020 and 2021. 
Gary then sells the property on January 1, 2022, for a $540,000 gain. 
His total ownership period is nine years (2013-2021). The first three years of post-2008 use as a vacation home (2013-2015) result in a non-excludable gain of $180,000 (3/9 x $540,000). Gary must report the $180,000 as a long-term capital gain on his 2022 Schedule D. He can shelter the remaining $360,000 of gain ($540,000 – $180,000) with his $500,000 gain exclusion. 
Key point. The last two years of use of Gary’s property as a vacation home (2020-2021) don’t count as periods of non-qualified use because they occur
after the last day of use as a principal residence (December 31, 2019) and  within the five-year period ending on the sale date (January 1, 2022).
Therefore, Gary’s use of the property as a vacation home in 2020 and 2021 doesn’t make his non-excludable gain any bigger. Good!

If the sale of your home will rub against these rules and you would like me to figure out your taxable gain, please call me on my direct line at 408-778-9651.

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