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Why do they say you will owe capital gains on the entire sales amount? That is not correct! Even if you had used it as rental property from the beginning, you would have had to have used MACRS depreciation, which depreciates a residential property over 27.5 years. So it would not be fully depreciated until sometime in 2018 or 2019.
Your basis for depreciation would be the FMV at the date you inherited the property back in 1991. You would calculate depreciation only for the period of time that it was rented out. So if you used it as your residence for several years, depreciation does not apply to these years.
Unfortunately, whether or not you actually claim depreciation while it was rented does not matter. The Internal Revenue Code is clear - it is depreciation "allowed or allowable". So even if you don't deduct the depreciation, but you could have, you have to reduce your basis by the amount that would have been deducted. Land is not depreciated, so you should separate the FMV when you inherited the property into the land and the building, and only the building gets depreciated.
You will pay tax only on your gain. The gain is the difference between the sales price and the basis. The basis is the FMV at the date you inherited the property, plus the costs of any improvements you made (roof, windows, furnace, A/C, carpet, etc) minus the depreciation for the periods that it was rented. So, for example, if the property was worth $150k when you inherited it, and $30k was land and $120k was building, and you rented it out for 12 of the 21 years you owned it, your depreciation would be $52,364 ($120k/27.5 * 12), so your basis would be $30k + $120k - $52.4k, or $97,636. If you sold it for $200,000, your gain would be $102,364. Any improvements you made would increase this basis. You would only pay tax on this gain.
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