Capital gains question

[kent]

My granddaughter and her husband are stationed in North Carolina and have a rental house here in California that they want to sell because of the "distance" issue and the fact that they will be relocating as his training progresses (Special Forces Physician Assistant for the time being)

They have owned the house for roughly two years and have NOT depreciated it.

They have asked me how they would be taxed if they sell it (there's a buyer, current renters of the place) that want it.

Annual W-2 income this year will be roughly $32,000. Married (obviously) with one child.

They stand to make $100,000 on the sale.

So, when capital gains are calculated, does the IRS look at W-2 income to ascertain what tax bracket they are in when calculating the capital gains tax? In other words, if they are in the 15% bracket based on W-2 income, what would their capital tax rate be on the $100,000 - 10%, 15%, 20%?

I hope this makes sense because I haven't got a clue.

I know you can't "bet" on internet advice but there seems to be several people on this board that actually know what they are talking about so any "planning" help/advice would be appreciated.

[TheOtherMe]

First, it does not matter whether or not depreciation was claimed.  In determining the basis of the house, the IRS considers depreciation allowed or allowable as being claimed.  They should amend the open years to claim the depreciation.

The depreciation then will be recaptured as Sec. 1250 property on Form 4797 once the property is sold.   Since depreciation is a deduction against ordinary income, it is recaptured as ordinary income.  

Was a Schedule E filed claiming the income and other expenses on the rental?  If not, that needs to be on the amended return also.  

After depreciation is claimed, they may have unclaimed losses as passive losses are limited to $25K per year.  Often depreciation kicks people in to a carry forward of the loss.  The sale releases the loss.

There will be other deductions against the W-2 income, such as personal exemptions and either the standard or itemized deductions to get to AGI.  From what I can tell, unless Congress changes things, somebody in the 15% tax rate would pay 0% on a long term capital gain.  However, if the Sec. 1250 recapture puts them in to a higher bracket, it would most like be 15%.  

I would advise since they did not claim the depreciation, a tax pro needs to be consulted to get this straightened out.

[mwcpa]

The only thing I would add is it is not only the IRS that "requires" the allowed or allowable aspect of the basis computation adjustments in regards to depreciation on property used in a business or rental operation, it is in the tax law too.

See a pro here (not a 10 week wonder), your granddaughter could be leaving money on the table for the last 2 years and will pay more than necessary upon the sale of the property.

[kent]

A day late but thanks to both of you! As suggested, I advised her to see a pro, NOT, a "tax mill."

As an aside, I have a copy of her Schedule E and while she listed everything else, she did not note depreciation (TurboTax return)

[TheOtherMe]

Do make sure she sees a tax pro.  The depreciation is considered allowed or allowable so even if she didn't claim it, she did for tax purposes when it comes time to sell.

[rangerj]

Note:

MACRS, that is section 168 of the tax code, "allows" 27.5 years for depreciation of residential rental property. Section 168 also states that if you chose to use an alternative rather than MACRS then the depreciation "allowed" is 40 years straight line. I do not recall if this election has to be "timely", that is made at the time the property is placed in service. This would in my opinion be worth looking at so as to reduce the amount of ordinary income due to depreciation recapture (IF any) as well as a minimal reduction in basis and consequently reduced gain. Just some thoughts.