I sold a rental property this last year. It had been rented for about 9 months 6 months were in 2017 and 3 months were in 2016. The house was lived in by my wife before we were married for two of the last 5 years. We were married in 2015. We are both older that 65 and eligible for gains on our home to be forgiven as we have not used any benefit as yet. Prior to renting the house and after my wife vacated her house to live in OUR house we spent about $25K to renovate the house. While the house was occupied our tenant informed us of a water leak and the insurance paid about $13k plus about another $5k out of pocket to put it all back together. What is the best way to treat this whole mess? I have delayed my taxes for 2017 to make sure I do the right thing. The house was shown as a rental in my 2016 taxes. I will be happy to answer any questions to make things clearer.
To maintain organization you should handle things in the order they occurred. Per your post you did report the conversion of the property from personal use to rental property on the 2016 tax return.
- Would I be correct in assuming you filed a joint return for your 2016 taxes and showed the conversion from personal use to residential rental use then?
"The house was lived in by my wife before we were married for two of the last 5 years"
That means on your 2017 joint return you will qualify for a maximum $250,000 tax exclusion on any gain. Your marital status has nothing to do with this. But it was your wife, and *only* your wife that lived in the house as her primary residence prior to conversion to rental. So the $250,000 exemption is for the time she occupied the house as her primary residence. You never occupied the house as your primary residence, so there is no capital gains exclusion for you. Only for your wife.
"We are both older that 65 "
Age has absolutely nothing to do with this particular tax break. So put it aside.
"Prior to renting the house....we spent about $25K to renovate the house. "
While I'm confident you reported this stuff on the 2016 return, please bring me up to speed so I'm not making wrong assumptions here.
On what date did your wife move out?
How long did the renovations take?
On what date was the property "Move in ready"? Now I'm not asking you what date a renter moved in after the renovations. I'm asking you what is the earliest date physically possible that a tenant could have moved into the house and occupied it?
I ask these questions to know the following:
- Date of conversion from personal use to rental would be the date *after* your wife moved out.
- Date in service, or the date the property was "available for rent" would be the earliest date a renter *could* have moved in.
Depreciation on the property starts on the date a renter "could" have moved in. That's called the "in service date" or "availability date".
Also, since you spent $25K on renovations for the property I am assuming that you know the difference between the following:
-a property improvement which adds to the property's cost basis and is listed and depreciated in the assets/depreciation section.
- a repair and/or maintenance expense which if incurred prior to the in service date is not a deductible rental expense. There are absolutely no exceptions to this, and if you try to make it look otherwise, it's the equivalent of hanging a sign out that reads "Hey! IRS! AUDIT ME NOW! I WANT TO PAY LOTS OF FINES, PENALTIES, INTEREST AND BACK TAXES! HURRY! PLEASE!"
"our tenant informed us of a water leak and the insurance paid about $13k plus about another $5k out of pocket to put it all back together. "
When did all this occur from start to finish? In 2017? Depending on what damages occurred and precisely what was fixed, it's perfectly possible for this to qualify as a property improvement, and not a repair. For example, if the burst water heater soaked the carpet and all the carpet throughout the house (or in a significant portion of the house) had to be thrown out and replaced, that's a property improvement.
Another thing to, is correctly dealing with and reporting the insurance payout.