It may be best explained by example. You bought the original house and lot for $50,000. Depreciated $25,000. You spent $100,000 demolishing the old house and building the new one. You sold it for $200,000.
Your cost basis is $100,000 + $50,000 - $25,000 = $125,000. You have a capital gain of $75,000 ($200,000 - $125,000 = $75,000), of which $25,000 is depreciation recapture (section 1250 gain).
In TurboTax (TT), I think it goes smoother if you report it as the sale of a business asset (Business items section of income), rather than reporting it in the rental income section. You enter $150,000 cost basis and $25,000 depreciation claimed.
Edited per martinmarks comment
ALTERNATE METHOD
The depreciation recapture can be avoided. Here's a revised example. Although the net capital gain calculation is the same ($75K), depreciation recapture (which is taxed at a higher rate than long term capital gains) is avoided.
You bought the original house and lot for $50,000 and broke down the cost as $25,000 for land and $25,000 for building. You fully depreciated the building $25,000. You spent $100,000 demolishing the old house and building the new one. You sold it for $200,000.
Your report the disposal of the original building as a sale for $0. $0 sale amount -$25K cost basis + $25k depreciation recapture = $0 capital gain.
Your cost basis for the new building is $100,000 + $25,000 for land = $125,000. You have a capital gain of $75,000 ($200,000 - $125,000 = $75,000).
In TurboTax (TT), I think it goes smoother if you report it as the sales of business assets (Business items section of income), rather than reporting it in the rental income section. You enter the disposal of the original building as a separate asset (property) sale from the new building with land.
