I sold an out-of-state rental property and had to report depreciation recapture as income -- can I subtract the part attributable to years before I moved to Virginia, since I never got a Virginia tax benefit from those deductions?

Plain-English summary

A married couple, Virginia residents, sold a rental property located in another state during the year at issue. Part of the taxable gain was depreciation recapture under Internal Revenue Code § 1250, which they included in their federal adjusted gross income (FAGI) as required. On their Virginia return, they subtracted the share of that recapture attributable to depreciation deductions they'd taken during the six years BEFORE they became Virginia residents -- reasoning that since they never received any Virginia tax benefit from those earlier deductions, taxing the recapture in Virginia now amounted to double-counting. The Department disallowed the subtraction and issued an assessment.

Why Virginia taxes it anyway: conformity has no built-in exception here. Virginia Code § 58.1-301 provides that Title 58.1's terms generally carry the same meaning as the Internal Revenue Code, and for individual income tax, Virginia starts the computation of Virginia taxable income with FAGI -- income properly included in a resident's FAGI is taxable in Virginia unless a specific Virginia modification exempts it (Chapter 3 of Title 58.1). It's well established, going back to the U.S. Supreme Court's New York ex rel. Cohn v. Graves (1937), that a state may tax all of a resident's income, even income earned outside the state. The Department had already addressed this exact issue in P.D. 98-158 (1998): an owner of a pass-through entity that sold a rental property couldn't subtract IRC § 1250 recapture attributable to periods of nonresidency (see also P.D. 95-109, P.D. 95-254, P.D. 04-31). Because the recapture was properly part of FAGI, and neither of Virginia's subtraction statutes (§§ 58.1-322.02, 58.1-322.03) provides a carve-out for recapture tied to pre-residency depreciation, the subtraction was correctly denied.

But an out-of-state tax credit may still be available. Separately, Virginia residents can claim a credit against Virginia tax for income tax actually paid to another state on earned or business income, or gain from selling a capital asset (Va. Code § 58.1-332 A) -- limited to the LESSER of what was actually paid to that state or the Virginia tax attributable to that same income, computed by a proration formula (P.D. 97-301). The couple hadn't indicated whether they paid income tax to the state where the property was located. If they had, the Department noted they could likely claim this credit by filing an amended 2022 return (attaching a copy of the return filed with the other state), within the deadline set by Va. Code § 58.1-1823.

Outcome. The denial of the subtraction was upheld. If the couple can show they paid income tax to the other state on the same gain, they may still recover some of the assessed tax through the out-of-state credit on an amended return; otherwise, the Department's records show the assessment has already been paid and no further action is required.

What this means for you

Anyone selling an out-of-state rental property that generates depreciation recapture

Expect the full recapture amount included in your FAGI to be taxable in Virginia, even for the portion tied to depreciation you deducted before you were a Virginia resident -- there's no Virginia subtraction for that, and this is a well-settled position going back nearly three decades of Department rulings.

Anyone in this position who also paid income tax to the state where the property is located

Don't overlook Virginia's ordinary credit for tax paid to another state -- it can offset some of the Virginia tax on the same gain (limited to the lesser of what you paid there or the Virginia tax on that income), but you generally need to file an amended return and attach your return from the other state to claim it.

Common questions

Q: I took depreciation deductions on a rental property before I moved to Virginia -- can I subtract the recapture on that depreciation when I sell the property as a Virginia resident?
A: No. Virginia taxes the full recapture amount included in your federal adjusted gross income; there's no subtraction for the pre-residency portion under current Virginia law.

Q: Is there any way to reduce the Virginia tax on this recapture?
A: If you paid income tax to the state where the property was located on the same sale, you can likely claim Virginia's credit for tax paid to another state, limited to the lesser of the tax you actually paid there or the Virginia tax on that income.

Q: Do I need to do anything extra to claim that credit if I didn't originally?
A: Yes -- file an amended Virginia return within the deadline in Va. Code § 58.1-1823, and attach a copy of the return you filed with the other state.

Citations and references

Statutes:

• Va. Code § 58.1-301 -- Virginia income tax terminology conforms to the Internal Revenue Code unless a different meaning is clearly required
• Va. Code §§ 58.1-322.02, 58.1-322.03 -- Virginia's statutory subtractions and deductions from FAGI (no carve-out for pre-residency depreciation recapture)
• Va. Code § 58.1-332 A -- credit for income tax paid to another state, limited to the lesser of tax actually paid or the Virginia tax on that income
• Va. Code § 58.1-1823 -- deadline for filing an amended return to claim a correction

Case law: New York ex rel. Cohn v. Graves, 300 U.S. 308 (1937) -- a state may tax all of a resident's income, including income earned outside the state.

Prior rulings the Department relied on (described here, not linked): P.D. 98-158 (10/20/1998) -- no subtraction for IRC § 1250 recapture attributable to a period of nonresidency; P.D. 95-109 (5/9/1995), P.D. 95-254 (9/22/1995), and P.D. 04-31 (7/12/2004) -- the same rule applied in earlier cases; P.D. 97-301 (7/7/1997) -- the out-of-state tax credit's proration formula.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 24-54

Original ruling text

May 22, 2024

Re: § 58.1-1821 Application: Individual Income Tax

Dear *:

This will respond to your letter in which you seek correction of an assessment of individual income tax issued to * and *** (the “Taxpayers”) for the taxable year ended December 31, 2022.

FACTS

The Taxpayers, Virginia residents, sold a rental property located in another state during the taxable year at issue. They included the gain on the sale, a portion of which was attributable to recaptured depreciation under Internal Revenue Code (IRC) § 1250, in their federal adjusted gross income (FAGI). The Taxpayers subtracted the portion of recaptured depreciation attributable to deductions taken during the six years when they were not residing in Virginia. The Department disallowed the subtraction, which resulted in an assessment being issued. The Taxpayers filed an application for correction of the assessment, contending that they should be allowed to subtract the recaptured amounts to the extent that they did not previously receive any benefit from the depreciation deductions for Virginia income tax purposes.

DETERMINATION

Conformity

Virginia Code § 58.1-301 provides, with certain exceptions, that the terminology and references used in Title 58.1 of the Code of Virginia will have the same meaning as provided in the IRC unless a different meaning is clearly required. Conformity does not extend to terms, concepts, or principles not specifically provided in the Code of Virginia . For individual income tax purposes, Virginia conforms to federal law, in that it starts the computation of Virginia taxable income (VTI) with FAGI, with certain exceptions. Income properly included in the FAGI of a Virginia resident is subject to taxation by Virginia, unless it is specifically exempt as a Virginia modification pursuant to Chapter 3 of Title 58.1 of the Code of Virginia .

It is well established that a state may tax all the income of its residents, even income earned outside the taxing jurisdiction. In New York ex rel. Cohn v. Graves , 300 U.S. 308, 312-313, 57 S. Ct. 466, 467 (1937), the United States Supreme Court explained “[t]hat the receipt of income by a resident of the territory of a taxing sovereignty is a taxable event is universally recognized.”

Subtraction of Depreciation Recapture

The Department addressed a similar issue in Public Document (P.D.) 98-158 (10/20/1998). In that determination, the Department held that an owner of a pass-through entity that sold a rental property was not eligible to subtract IRC § 1250 depreciation recapture attributable to deductions taken while the taxpayer was not a Virginia resident. See also P.D. 95-109 (5/9/1995), P.D. 95-254 (9/22/1995), and P.D. 04-31 (7/12/2004).

Because the depreciation recapture was included as income in FAGI, it must be included in the computation of VTI as a result of Virginia’s conformity to the IRC. Virginia law does provide for certain subtractions and deductions from FAGI. Neither Virginia Code § 58.1-322.02 nor § 58.1-322.03, however, provides a subtraction or deduction for IRC § 1250 depreciation recapture attributable to periods of nonresidency. As such, the subtraction was properly denied.

Credit for Taxes Paid to Another State

Virginia Code § 58.1-332 A allows Virginia residents a credit on their Virginia returns for income taxes paid to another state provided the income is either earned or business income or gain from the sale of a capital asset.

Virginia law does not necessarily allow a taxpayer to claim a credit for the total amount of tax paid to another state. Rather, the credit is limited to the lesser of the amount of tax actually paid to the other state or the amount of Virginia income tax actually imposed on the taxpayer on the income earned or derived in the other state. See P.D. 97-301 (7/7/1997). The limitation is computed by multiplying the individual’s Virginia tax liability by a fraction, the numerator of which is the income upon which the other state’s tax is imposed, and the denominator of which is Virginia taxable income.

The Taxpayers did not indicate whether they were required to pay income tax to the state where the property was located for the taxable year at issue. If they did, however, they likely would be entitled to claim a credit for any such taxes paid on the sale of the property to the extent permitted by Virginia Code § 58.1-332.

CONCLUSION

For the reasons stated above, the denial of the subtraction was correct and is upheld. If the Taxpayers are entitled to a credit for income tax paid to the state in which the property was located, they may file an amended 2022 Virginia resident income tax return to claim the credit to the extent permitted by Virginia Code § 58.1-332. The credit may be granted so long as the amended return is filed within the time prescribed under Virginia Code §58.1-1823. The Taxpayers should also attach a copy of the 2022 return they filed with the other state. The return will be reviewed and processed, and the assessment will be adjusted as warranted. Otherwise, the Department’s records indicate that the assessment has been paid and no further action is required.

The Code of Virginia sections and public documents cited are available on-line at www.tax.virginia.gov in the Laws, Rules & Decisions section of the Department’s web site. If you have any questions regarding this determination, you may contact * in the Office of Tax Policy, Appeals and Rulings, at (804) ***.

Sincerely,

James J. Alex

Tax Commissioner

Commonwealth of Virginia

AR/4704.X

Related Documents

95-109

95-254

97-301

98-158

04-31