Adding New Owner to Rental Property: How to split depreciation?

[SFAllMyLife]

Software: TurboTax Premier 

Background:

Year 2019: {S1} is sole owner of rental property & has been taking depreciation deduction for 10yrs.

- cost basis = $100,000 / 27.5yrs = $3,636 per yr

- at end of 2019, NBV = $100,000 - ($3,636 x 10yrs) = $63,640

Year 2020: {S1} has financial issues. Rental Property is re-financed. Now Rental Property ownership is {S1} & {S2} as JOINT TENANTS. For simplicity, let's just say split is 50/50.

Splitting of income & expenses is easy, BUT what happens with depreciation?

Questions:

1) {S1}'s NBV is $63,640.  How to move forward if {S1}'s share is 50%. Will depreciation be half of the $3,636?

2) {S2} will have a new asset to depreciate? Is the cost basis at FMV or do we take the existing NBV, amortize over remaining life of asset (27.5-10 = 17.5yrs)?

I have been reading all over. Found things about people marrying & combining. Cases of inheritance, but I can't find anything on this.

Thanks so much for all you help!!!

[Carl]

I am assuming you refinanced only for the outstanding balance on the loan, and did not take any cash out. If you did take a cash out, that changes things significantly.

Overall, I would highly suggest you seek professional help for this tax year with this, and if you are not married to the new additional owner and filing a joint tax return with them, you two form a partnership. That way, everything concerning the rental gets reported on a 1065 partnership return. The partnership issues each owner a K-1 which will be required by each owner to report their share of everything on their personal 1040 tax return. Otherwise, if you want to do it the more complicated way, keep reading. I do not suggest the below, especially if your state also taxes personal income. But it's an option.

Convert the property and all it's assets to personal use with a conversion date of one day before you closed on the new loan. 

After the conversion, work through each individual asset one at a time again and do not change anything. You need to write down the total of all prior year's depreciation already taken, and add it to the current year (2020) depreciation taken up to the date of conversion. This will give you the total depreciation taken on that asset.

Now subtract the total depreciation taken on the asset, from the original cost basis of that asset. That is your "new" cost basis now.

Enter the property as a completely new asset using the new, lower cost basis with an in service date of the day after you converted it to personal use. (This would be the closing date on the new loan.)  For you as a 50% owner your cost basis would be half of the adjusted cost basis you obtained by subtracting the depreciation already taken on the property, from the original cost basis. 

Take note that you do not and can not split the depreciation between you and the new additional owner. That's because *YOU* and you alone took all that depreciation. Therefore you, and you alone will subtract "all" (100%) depreciation that *you* took, from your 50% of the cost basis.

Depreciation will start over for you from year one with .with 2020 being the first of 27.5 years.

The new additional owner will enter it on their tax return using 50% of the original cost basis, but the new additional owner will *not* reduce that since the new owner did not have any ownership in the property prior to the new loan, and therefore has no prior depreciation to report or claim.

Overall, I do not believe the TurboTax program is capable of mathematically handling this correctly at all.

[SFAllMyLife]

Thanks so much for your reply!! I just read your response & there is a lot of good details. I will re-read. I want to take the more complicated route you outlined. Thank you!

Add'l details:

* No cash was taken out in the refinance.

* I really want to avoid the Partnership return because {S1} hopes to refinance again in the future and become sole owner of the rental property.

* Since {S2} new owner is willing to step in to help out financially, it would make sense that {S2} get a portion of the depreciation expense.

[Carl]

Since {S2} new owner is willing to step in to help out financially, it would make sense that {S2} get a portion of the depreciation expense.

That's not an option. You, and you alone deducted all the prior years of depreciation. Therefore when you sell or otherwise dispose of the property in the future, it's you and you alone are required to recapture all that depreciation and pay taxes on that recaptured depreciation.

Remember, depreciation is not a permanent deduction that you get to "deduct and forget". It has to be accounted for at some point in the future, by the individual or entity that took that depreciation deduction.

However, I seriously doubt the TurboTax program can "correctly" handle the situation mathematically. That's why I believe you will need to use TurboTax Business to complete and file a 1065 partnership return if you wish to continue to use TurboTax to track and report this stuff.

Even then, because of the complexities of your specific situation, I'm not even confident that TurboTax Business can handle it correctly. Therefore I highly recommend professional help for at least the 2020 tax year in dealing with this.

Even the tiniest of mistakes will grow exponentially over time. Then when the mistake is realized, usually in the year of sale or other reportable transaction, the cost of fixing it will be high, and will make the cost of having obtained professional help at the start seem like a pittance in comparison to the potential back taxes, fines, penalties, interest and any other items that may be assessed for your blunder.

[SFAllMyLife]

@Carl Thanks so much for taking the time to share your advice! It is much appreciated!

I wanted to ask a follow up question related to the original question posted related to the original owner {S1}:

Depreciation will start over for you from year one with .with 2020 being the first of 27.5 years.

Original basis	100,000
less AC	36,360
NBV	136,360
{S1} - 50% share	68,180

Since {S1} has already deprecated the asset for 10 years, is it treated as a new asset and depreciated for 27.5yrs or 17.5yrs (27.5 less 10 yrs)?  I've read how you cannot extend beyond the 27.5yrs but maybe this is a different situation? 

Alternatively, is it an option to just leave the same depreciation for {S1} & just let it run it's course? {S1}'s 2020 year income is so low that it makes no difference. All the allowable passive loss is lost because there is not enough income to absorb it.

Thanks again!

[Carl]

Since {S1} has already deprecated the asset for 10 years, is it treated as a new asset and depreciated for 27.5yrs

Exactly. 2020 will be the first year of the next 27.5 years of depreciation.

Alternatively, is it an option to just leave the same depreciation for {S1}

No. It is not an option. By reducing the cost basis by the depreciation you have already taken you are "in fact" recapturing that depreciation. But, you won't pay taxes on that recaptured depreciation until the tax year you sell or otherwise "completely" dispose of your total interest in the property in a fully reportable and taxable transaction.

[SFAllMyLife]

@Carl Thank you so much for all your help!!

[grich632021]

I read the responses but still have question. The other owner is now my spouse. She and I have owned 50/50 of the rental house since 2011, both of us have been taking depr and filing as single. All prev years heve been prepared using TT so I have all the records from prev years.

[Mike9241]

regardless of whether owned through an LLC, qualified joint venture, or otherwise, my tax literature states in effect; 

where there's ownership by an LLCs or QJV, each spouse must report separately their share of income and expenses on schedule E 

per the iRS

A qualified joint venture is a joint venture that conducts a trade or business where (1) the only members of the joint venture are a married couple who file a joint return, (2) both spouses materially participate in the trade or business, and (3) both spouses elect not to be treated as a partnership.

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Spouses are treated as one taxpayer for purposes of the passive loss rules. If you are married for the tax year, your participation in an activity includes your spouses participation. The hours of participation in an activity by both spouses are combined in applying the test for material participation to each spouse.

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it may be best regardless of the circumstances to each file a schedule E with the joint return.