Investors & landlords

@Anonymous.  I don't disagree with your position, with a caveat, which I'll get to.  And I could be wrong in what I present, but here's the point:  the position you take must be defendable before the IRS.  I will concede the point that the expenses in this scenario must be capitalized with the 

Probably more "technically correct" under this situation is treat the expenses as a "separate" depreciation element, This would be consistent with how the IRS normally would treat a capitalized improvement.  

But for you, this leads to some complicated calculations, because you have three separate elements:  you would have to re-calculate your original depreciation (see my example in my prior answer, which still applies), you would have a deduction of $2,000 for casualty loss (which lowers the FMV of the house by $2000), and then a restoration valuing $14,000 (the reimbursed portion of the casualty by the insurance for which you must capitalize the expense).  With whatever remaining depreciation you have left on the property, you will now have two separate depreciations:  The adjusted depreciation schedule-$16000 (the full reduction of original basis, which now means that you that you are recalculating the original house basis manually on $194,000 instead of $210,000); and a new $16,000 restoration depreciation which is depreciated over 27.5 years.  All of this is to claim $2000 of loss expense this year, and the $2000 of loss is "reinvested" back into the basis (as part of the $16,000 depreciation element.  In this scenario, you are "cashing in"  on $2000 of unreimbursed loss, and then reinvesting that back into the building out of pocket, so that must be capitalized.

As described above, your situation is actually a mix of Example 3 and Example 4, because you have a partial insurance reimbursement.

Maybe @Carl sees something I don't, but for the amount of adjustments you need to make to get this technically correct, it's more trouble than it's worth.  You will notice in your example that the phrase "properly reduced the basis".  This gives rise to a gray area:  what if the basis is not "properly" reduced.  In that situation the basis remains the same, and you simply continue depreciating the original value of your basis, without claiming any of the casualty loss.  If the depreciation is fully taken over the life of the property, the end result of how much of the value of the property was used  via depreciation would be the exact same.  All of the adjustments in paragraph 2 amount to 210,000, and your original basis is 210,000.  If the IRS were to quibble with the calculations, it would come up on the sale of the property due to depreciation recapture.  At the time of sale, you would need to pay tax on the larger of:

• Depreciation taken
• Depreciation allowable

Doing the math in my head, maintaining this as a simple equation (keep depreciating "as-is") will result in taking more depreciation, but not a huge amount more, than what is technically allowable.  In all likelihood, they will be just fine with this because they will get the taxes back when you sell the house.  Only in the case where depreciation taken is less than depreciation allowable would there be a depreciation recapture issue.

I can't cite tax case law of a specific decision regarding this, so in the end it's your decision.  But I believe you to have a defendable position with very little risk by not reporting all the movement by reducing the basis.  

And if you want to do this, and are unsure on the tax legality, you can use Form 8275 and cite the tax regulation you researched to disclose your position on leaving the basis "as-is".