Allocating basis and sales to a duplex: Rental vs. Home Use

[decogeek]

Hello,

I have an interesting situation which might affect other people, but I've never seen the issue addressed.

Think about a 120 year old duplex. I have owned it for 30 years, so the whole thing has been remodeled. The upstairs apartment has a pretty classic layout with wood floors. It's a typical apartment, so in 30 years the floors were resurfaced once and the kitchen and bathroom have been updated with nice, but apartment quality stuff.

The downstairs, where I lived has been totally upgraded with custom cabinets, custom flooring, a wall was torn out to create an open floor plan with a breakfast bar. The basement was totally finished, drywalled, carpeted, etc. The "home" portion of the property may have gotten $40,000 of remodeling in 30 years, while the "rental" part of the property may have gotten $5000 worth of remodeling. The square footage of the rental portion is 35.5% of the house.

The IRS instructions say to allocate 35.5% of the sales price to the rental, but only the $5000 of increase to the basis. Obviously, this is not a fair allocation since most of the increase of the home's value came out of the significant changes to the "home" portion of the property. In this situation, am I allowed to take 35.5% of the full $45,000 of remodeling against my "rental" portion of the property? Even this way would overstate the gain attributable to the rental portion. Is there more than one way to allocate changes to basis? What is considered a fair method in a situation like this?

I appreciate any and all input. Thanks for reading!

[Critter-3]

First you NEVER want to depreciate the property any faster than required ... so first remove the land value from the equation  then divide the duplex  purchase costs in any reasonable method you can defend in an audit ... usually square footage is good way.  Then add to that base basis the improvements made to the rental portion to use for the cost basis for depreciation purposes.  

[Zeek77]

I have the exact same issue, and it hurts my brain to even think about. I had duplex that had a larger owners unit, and I did some major renovations in my unit only. 

Someone help us please!

[Zeek77]

I think the method you suggested is the only fair way to do it, however, instead of allocating 35.5% of the $45,000 against the rental portion of the property, I think it should be 35.5% of the total renovation cost of 50K that should be allocated to the rental portion. 

Another idea would be to use data on what percentage of home improvements are recouped when they are sold. For example, if your 45K was for a kitchen, and say people recoup 70% of that (just a guess), then take that percentage off the home sale cost. I will add an example. 

[Carl]

If the property improvements were all done before any portion of the property was converted to a rental, then your cost basis in the entire property structure (without including the land value) is what you paid for it, plus what you paid for all property improvements. Then take 35% of that for the rental portion. Example:

-Purchased property in 2000 for $50K

- Between 2000 and 2015 you did a total of $20,000 in property improvements.

- Started renting 35% of the floor space in 2020.

Step one, determine your cost basis split between structure and land based "soley" on your original purchase price of $50K.

a. Your latest property tax bill shows a tax value of $30K with $7K assigned to the land. So 23% of the tax value is the land.

b. 23% of your original purchase price of $50K is $11,500. So the land value is $11,500. (None of  your property improvements to the structure change the cost basis of the land.)  This means $38,500 of your original purchase price is assigned to the structure.

c. Add your property improvements to the structure value and you get $58,500 for the structure value.

Now in the program it will ask you for the total value (structure and land together) You'll enter $50,000 in the "Cost" box, and the land value of $11,500 in the "cost of land" box. Then the program (not you) will do the math to assign $38,500 to the structure.

Then depending on your other selections in the program, 35% of that gets depreciated over the next 27.5 years. Weather you manually figure the 35% or the program does it for you, depends on your selections in the program.

[Zeek77]

Carl,

Thank for clarifying how to calculate the cost basis and input into turbo tax, but it doesn't answer the original question. 

The problem the original poster and myself have is, we did improvements while the property was an owner occupied duplex, so obviously the owners portion can be exempt from capital gains (up to 250K), but the rental side is not.  When we sell the property, we've increased the value of it considerably due to almost all the renovations on the owner occupied unit. So we end up selling the property for a lot more than we paid for it, and on the rental side, we are screwed because it looks like also increased the value of the rental side due to the overall sale price being higher from renovations. 

So the question is, how can we divide up the gain in value on the rental side without just taking the 35% of the sale price minus the 5K he did in renovations on the rental and minus 35% of the original cost of the property? This method is not fair, because the property sold at a higher price due to the 45K he put in on the owner's side. 

His suggestion of proportioning out the renovation cost over both units seems like the best method, unless someone has a better suggestion. 

[Carl]

@Zeek77 what you can do is just convert everything to personal use on the closing date of the sale. That will give you the total depreciation you're required to recapture in reporting the sale.

Then, split your sales data between the two units based on the percentage of the cost basis of the entire structure that was used for depreciation of the rental portion.

Next, report the sale of the rental portion in the Sale of Business property section.

Finally, assuming the unit that was your primary residence was never classified as a rental or any other business use that required you to take depreciation, report the sale of the primary residence portion in the "Sale of Home (Gain or Loss)" section.

[vanda1]

Where did you find this info: "The IRS instructions say to allocate 35.5% of the sales price to the rental"?

[decogeek]

The 35.5% is the percent of my house that is the rental apartment. The IRS publication 523 is what I was referring to.