Can you deduct depreciation in year of sale? For Sec 1250 residential rental property?
-David, PA
Dear David,
Thank you for sending us your most excellent question. I imagine you might read this response amid a flurry of boxes, packing paper, bubble wrap, and tape! You asked if you may claim a depreciation deduction for Section 1250 residential property in the year the property is sold. When it comes to taxes, details matter, especially when calculating deductions that may impact the overall gain or loss from the sale of a significant asset like real estate. Before getting to the nitty gritty of your question, allow me to make some assumptions, for the Tax Code is as wide and deep as the ocean. And as the ocean is filled with treacherous riptides and currents that can take you to places you never wanted, the Tax Code can lead you down winding paths and tunnels from which some tax scholars have never returned. Based on the wording of your question, I will assume you are referring to a residential home or condo that you own and have been renting out. Since you did not mention you lived at the property or used it occasionally as a vacation home, I will gather there was no personal use.
First, let's address a couple of questions some folks might be grappling with – What is depreciation? and What on Earth is Section 1250 residential property? In the world of taxes, depreciation is the method used to allocate the expense of a tangible or physical asset, like furniture, a building, or a car, throughout its useful life. For example, if you purchased a new water heater for your residential rental, the cost would be depreciated over the course of seven years.
Section 1250 refers to a part of the Tax Code. According to the Internal Revenue Code (IRC §1250(c)), Section 1250 property is:
"For purposes of this section, the term 'section 1250 property' means any real property (other than section 1245 property, as defined in section 1245(a)(3)) which is or has been property of a character subject to the allowance for depreciation provided in section 167."
Now, who says the IRS doesn't have a sense of humor? Allow me to translate the above into English. Generally, Section 1250 property refers to real property such as commercial buildings, single-family homes, mobile homes, and other assets such as farm buildings (a barn) and their structural components. An example of a structural component is a roof.
The cost of a residential rental property, like a single-family home or duplex, can be depreciated for 27 and a half years if the property continues to be rented or is ready and available to rent. What happens if you decide to sell the residential rental property before you have finished depreciating the entire cost? Do you get to claim the rest of the depreciation in the year of sale, or, worse, are you not allowed to claim a depreciation deduction at all? The answer is somewhere in the middle. As long as the property had not been taken out of service as a rental property (apart from selling the property) and converted into a primary, second, or vacation home, or other personal investment property, you should be able to claim a depreciation deduction in the year of the sale, although it will be limited. For depreciation purposes, in the year a residential rental home or other Section 1250 property is sold, the sale is considered to have taken place in the middle of the month the property was sold. It does not matter if the property was sold on the 1st or 26th day of the month. This is known as the Mid-month Convention. Here is an example.
Daniel received a sizable cash inheritance from his great-uncle Wes in March 2018. Wanting to put his windfall right to work, Daniel purchased a condo in his hometown of Pittsburgh, Pennsylvania, for $195,000. On June 1st of the same year, Daniel began renting the home to a young family.
Wanting to invest in another property, Daniel decided to sell the condo. On May 27, 2022, he sold the condo for $225,000. If Daniel had continued to rent out the condo for all of 2022, his depreciation deduction on the condo would have been $7,091. However, since Daniel sold the condo on May 27, 2022, his depreciation deduction was calculated using the Mid-month Convention. Daniel's depreciation deduction for 2022 would have been calculated as if the property was in service for four and a half months, calculated as follows:
Total depreciation for the year = $7,091
Depreciation deduction for 2022: $7,091 x 4.5 (months) ÷ 12 (number of months in a year) = $2,659.
There are a couple of essential rules to keep in mind regarding the depreciation of real estate, like a residential rental home. First, the cost of the land, which is part of the purchase price of real estate is never depreciated. If the purchase contract doesn’t specify how much of the purchase price is for the land, the taxpayer needs to make a reasonable allocation to determine how much of the cost can be depreciated. In the example above, Daniel purchased a condo. Even when a condo is purchased, a portion of the purchase price, albeit small, represents land. For simplicity’s sake, we did not allocate a portion of Daniel’s condo to land. However, if we did, a portion of the cost that represents the value of the land would not be depreciated. Presuming Daniel’s condo was purchased for $195,000 and the cost of the land was $15,000, then the remaining $180,000, which represents the cost of the condo itself, would be depreciable.
The other rule to remember is that when the house is sold, the gain or loss from the sale is calculated using the
home's adjusted basis, not the original purchase price. One of the adjustments considered is any depreciation that was
allowed or allowable. Returning to our example, let’s assume Daniel never took a depreciation deduction for the condo. This does not mean Daniel's basis in the condo when he calculates the gain or loss is $195,000. Daniel would need to calculate the amount of depreciation he should have taken (i.e., was allowable) from the date the condo was placed into service as a rental to the date it was sold and subtract that amount from the purchase price. From June 1, 2018, through May 27, 2022, the amount of depreciation Daniel was allowed to claim was $27,773, calculated as follows:
Depreciation for 2018 was $3,841 + depreciation for years 2019 through 2021 was $7,091 a year ($7,091 x 3 = $21,273) + depreciation for 2022 was $2,659 = $27,773.
Daniel's adjusted basis in the condo is $195,000 - $27,773 = $167,227. His taxable gain on the condo sale is $57,773 ($225,000 - $167,227 = $57,773).
You noted that you are a resident of Pennsylvania. Since you did not mention otherwise, I assume your residential rental property is in Pennsylvania. Fortunately, when it comes to the Section 1250 residential rental property depreciation rules, Pennsylvania conforms to the federal treatment. Unless you have an extraordinary tax situation, you should not have to make special adjustments when calculating depreciation on your Pennsylvania state return. And that is good news indeed.
Wishing you success in all your property endeavors and many happy returns,
Jean Lee Scherkey, EA