When rental property is sold (or deemed to be sold, as on a death) there is a tax disposition.

If the property has appreciated in value, there may be a tax liability on any capital gains from the purchase price. The capital gain would be split between the land and the actual rental building. If depreciation was expensed on the building (land is not a depreciable asset) the rules become more complicated. If the depreciated value of the property is less than the purchase price or sale price of the property, there is “recapture” of the depreciation charged. Conversely if the depreciated value is greater than the sales price of the property a “terminal loss” is created. These rules don’t apply if the rental property is your personal residence and depreciation was not claimed.

For example, John purchased a property for $200,000 ($50,000 for the land and $150,000 for the building) and over the years had depreciated the building to $120,000. He subsequently sold the property for $250,000 with the value of the land now $80,000 and the building $170,000. Therefore, there is a capital gain of $30,000 on the land (the difference between the cost of the land and the sale\s price). There is a profit on the building which must be split in two portions. Firstly, there is a capital gain of $20,000 on the building (the difference between the original cost of $150,000 and the sale price of $170,000) and a recapture of depreciation of $30,000 (the difference between the cost of the building [$150,000] and the depreciated value [$120,000]). John has both a capital gain and a recapture to report. There is a total capital gain is $50,000 of which only one half ($25,000) is taxable income. The recapture of $30,000 is taxed as regular income on John’s tax return at his marginal tax rate.

In this example, what if John sold the property for $190,000 ($80,000 for the land and $110,000 for the building? In this case he would still have a $30,000 capital gain on the land but would have a $10,000 terminal loss on the building (the difference between the depreciated value of $120,000 and the sale price of $110,000). As the terminal loss is fully deductible, he is able to apply it against his capital gain and is therefore taxed on one-half of $20,000.

If you utilize a portion of your home to earn rental income, as long as you meet certain criteria you can shelter any capital gains on the sale of same by claiming the principal residence exemption. These criteria are that the partial use of your residence for income producing is ancillary to its main function as a residence, that no structural change has been made to the property, and no capital cost allowance (depreciation) has been charged to the property. If you can’t meet all these criteria you may face some tax if you sell your residence for a gain.

June 18, 2008