Can I include Roof replacement done by Seller part of rental property assets valuation

[narayananvm]

Here is my situation: I purchased this property as my primary residence on 2019. During the contract period, I found and reported major issues with Roof. Sellers acknowledged and used their home insurance policy to replace the roof. I still bought it for the same old appraised price. I did couple of property improvements during my stay. Fast forward on September last year, I moved out and converted it to a rental property. Given this context, can I include or exclude property appreciation for 3 year old roof among other improvements done?

[ee-ea]

See this from the IRS

https://www.irs.gov/publications/p527#en_US_2022_publink1000219151

[narayananvm]

Sorry, I really didn't quite understand which precise section this link is pointing to. Can someone clarify the existing IRS rules w.r.t to my specific situation i.e. Seller replaced roof part for us, the buyers, during closing process based on the negotiations between us?

[PatriciaV]

Your cost basis begins with the actual amount you paid for the home. Improvements (whether paid by you or someone else) may influence the Fair Market Value (appreciation), but not your basis.

According to IRS Pub 551 Property Changed to Business or Rental Use: 

If you hold property for personal use and then change it to business use or use it to produce rent, you must figure its basis for depreciation. An example of changing property held for personal use to business use would be renting out your former main home.

The basis for depreciation is the lesser of the following amounts.

• The FMV of the property on the date of the change, or
• Your adjusted basis on the date of the change.

The best source for the Fair Market Value (FMV) on the date of the change would be a local real estate agent who can provide comparable sales. This is good evidence for the value of your home on that date.

Your adjusted basis is the original purchase price plus any improvements (upgrades or additions) that you have made. Historical property tax records may provide the price you paid for the home. Improvement costs would come from your personal financial records.

In most cases, your adjusted basis would be less than the FMV, so that is the basis you would use for your Rental Property.

[Carl]

Note also that for depreciation, you are required to use the *lower* value of:

1. What you paid for the property when you originally acquired it, plus what you paid for any property improvements after you acquired it, or;

2. The FMV of the property on the date you converted it from personal use, to a rental.

Since "you" did not pay for a new roof separate from the contracted purchase price, whatever the roof costs does not get figured in or added to the basis. Since the seller paid for it, the seller (not you) would get to add that cost to their cost basis to reduce their taxable gain on the sale.

While not impossible, I seriously doubt that the FMV of the property on the date you converted it to a rental, was lower than your acquisition costs. So you would use your acquisition cost, plus the cost of any property improvements that *you* paid for.

[narayananvm]

@Carl @PatriciaV Thanks for the prompt response. I understand, I should not include the cost for roof replacement for the adjusted cost basis calculation. Follow up question: When I sell this rental property in future, will the depreciation claimed during the rental years be recaptured from the sale or not? What if I do 1031 exchange, will these depreciated amounts be recaptured still?

[Carl]

If/when you sell the property in the future, you are required to recapture and pay taxes on depreciation in the tax year of the sale. Even if you don't depreciate the property, you are still required to recapture the depreciation you *should* have taken, and pay taxes on it in the tax year of the sale. Two things about that:

1) Recaptured depreciation is added to your AGI in the tax year of the sale. So it has the potential to bump you into the next higher tax bracket. Weather it does or not, just depends on the numbers.

2) Recaptured depreciation is taxed as ordinary income anywhere from 0% to a maximum of 25%. Again, it just depends on the numbers.

As for a 1031 exchange, I really can't provide any useful information on that, as I'm not well versed with 1031 exchanges at all. I'll leave that for someone else to address.

[narayananvm]

Thanks @Carl, good to know! Apologies to beat the dead horse, but curious: If the recaptured depreciation is treated as Ordinary Income, how come there is a "max of 25%"?

Yes, it will be helpful if someone can shed some light if the recapturing process can be avoided when doing 1031 exchange. Thanks.

[narayananvm]

I researched further (thanks to https://www.wallstreetmojo.com/depreciation-recapture/) and understood the following:

1. The recapture of depreciated amounts are, as you had explained, treated as ordinary income but limited to a max of 25% tax.

2. The capital gains and the recapture of depreciated amounts of the rental property can be deferred by properly executing a 1031 exchange.

Is my following understanding correct?:

For folks who has top tax brackets higher than 25% this is actually an advantage because they are allowed to deduct their rental income over years via depreciation deduction which saves higher taxes on their ordinary income. Moreover, rental incomes are subject to net investment income taxes which saves another 3.8%

[RobertB4444]

Your understanding of the first is correct.  I assume that you meant NOT subject to investment income taxes in which case you would also be correct.

@narayananvm 

[narayananvm]

@RobertB4444 Thank you for the clarification. Yes, I did mention about investment income tax. This is great overall, then!