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Imagine this scenarior:

  • Year 2018 - Purchase duplex for $1M. Begin taking depreciation deduction for the home (not land) value.
  • Year 2019 - Various repairs $25,000
  • Year 2019 - Capital Improvement $25,000 (newfurnace)
  • Year 2021 - Capital Improvement $25,000 preparing for sale (replace water heater)
  • Year 2021 - Staging cost for sale $10,000
  • Year 2021 - Sell property for $1.1M

The capital improvements will not be fully depreciated. How do these partially depreciated capital improvements factor into the cost basis for sale... and the recapture of depreciation?

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Your adjusted basis is original basis + expense of sale (includes staging but also other costs) − depreciation allowed or allowable + capital improvements. You can see this on Form 4797, Part III; rental property is most likely section 1250. In your example, it'd be $1.06 million minus depreciation (hopefully you took depreciation on the furnace and water heater after they were placed in service as well).

So for a capital improvement that has been fully depreciated, the depreciation recapture and the cost of the improvement will cancel out, and there will be no net effect on the adjusted basis. For a capital improvement that was put into service immediately before the sale, there is no depreciation, and the whole amount is added to your basis. For you it's in between; the net amount that was not depreciated is added to your basis.

You'll pay depreciation recapture on the depreciation allowed or allowable; it's taxed like regular income up to a maximum rate of 25%. The rest should be long-term capital gains. The only other cost you mentioned is repairs, which presumably you've already deducted on Schedule E, and if you haven't been able to take the full deduction you should be able to this year.

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  • Imagine I could either repair a water heater for $500 with new parts, or replace the water heater for $500. From a tax point of view what's better, after sale? The repair comes straight off income. The replacement depreciates for a few years... then the depreciation is recaptured. What's the net difference?
    – Bryce
    Oct 14 at 0:42
  • @Bryce Repairing is pretty much always superior from a tax perspective. To what extent depends on many variables, like tax rate while depreciating versus tax rate when selling, the time value of money, etc.
    – Craig W
    Oct 14 at 1:35
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The depreciation expenses that you claimed lower the cost basis for the house, increasing the amount of capital gain you are taxed on (subject to any exemptions, etc.)

So your cost basis will be the initial price of the house (plus some closing costs potentially), plus any capital improvements , minus any depreciation claimed. It does not matter if the house or the improvements are fully or partially depreciated - they are included in the capital gain from the sale.

In essence, depreciation just defers the tax to the time of sale (unless the house is inherited, which is a different set of rules).

(This is not professional tax advice; please see a CPA if you are not comfortable with using this general advice on your own)

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  • Imagine I could either repair a water heater for $500 with new parts, or replace the water heater for $500. From a tax point of view what's better, after sale? The repair comes straight off income. The replacement depreciates for a few years... then the depreciation is recaptured. What's the net difference?
    – Bryce
    Oct 14 at 0:43
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    I could be wrong (I am not a CPA which is why I recommended you find one) but the expense is deducted in that tax year and the depreciation is deducted over several years. All else being equal, deductions now are better than deductions later.
    – D Stanley
    Oct 14 at 13:16

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