I'd go with HalAl's 2nd choice because I am convinced that's the right way to report this deal. BUT you have to add the demolition costs to the land and the old house is fully depreciated and GONE with no disposition. That means you do nothing with the old house.....it doesn't exist anymore. The new house sale is short term gain for the house and long term for the land. Unless you sold the new house for a lot more than you paid to have it built, there shouldn't be too much gain.
One thing for sure is you can't treat the houses as a single asset.....they're not the same and depreciation can't be applied to the new house no matter what. You didn't improve the property.....you destroyed one asset and built a different asset.
