Why is TurboTax classifying depreciation recapture as long term capital gain?

Forum|Forum|3 years ago
March 4, 2023
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Hello,

I sold a rental property in 2022 for a gain. I can't figure out why TurboTax is classifying a portion of the depreciation recapture as long term capital gain. Here is a detailed description of what is happening.

When I put the property into service as a rental, I listed the values of the original structure and land. Then I listed out all the individual improvements I had made and the amounts I had paid for them. Over the course of a couple years, I took depreciation on the original structure and the improvements. Now when I'm selling, I have gone into the program and listed the sale price of each individual improvement to be equal to the undepreciated price I originally paid for the improvement. This ensures that the program is recapturing all the depreciation I took on each individual improvement as ordinary income.

The issue I'm having is the depreciation I took on the original structure, which is classified as "residential rental" under type of asset (I believe this was the default for the original structure and land when I allocated values to those items upon putting the property into service as a rental). When I look at form 4797, it is listing the depreciation on the original structure as a long term capital gain, which it then sends over to Schedule D, Line 11 for purposes of calculating capital gains tax.

My understanding is that all depreciation recapture is supposed to be taxed as ordinary income. Is the program correct in instead classifying the depreciation on the original structure as a long term capital gain? Or have I accidentally put something in wrong?

Thanks!

NDiMasAuthor

Answering my own question here. It is because the depreciation on the original structure is considered "unrecaptured Section 1250 Gain." This article explains it well:

https://www.investopedia.com/terms/u/unrecaptured-1250-gain.asp#:~:text=An%20unrecaptured%20section%201250%20gain%20is%20an%20income%20tax%20provision,at%20a%2025%25%20maximum%20rate.

I was unaware that the depreciation on the original house structure is considered a capital gain and can be offset by other capital losses. According to the article, that is the case.

It's interesting to me that the improvements I made over time are considered personal property, are classified as Section 1245 property, and therefore the depreciation is taxed as ordinary income rates and cannot be offset by capital losses. But the original house structure is considered residential real estate, is classified as Section 1250 property, and therefore the depreciation is treated as a capital gain that can be offset by capital loses and is subject to its own separate maximum taxation rate. I don't understand why it should work this way, but it does appear to be the case, based on what I have read.

Mike9241

you may have misclassified the improvements. if they become a permanent part of the struct they are real property

NDiMasAuthor

Thanks, Mike. That does make sense. If I did misclassify some of the improvements, is it acceptable to reclassify them now at the time of sale, or will that mess up the depreciation calculations?