Background: The rental property is co-owned by me (Oscar) and my mom. The house was purchased under both of our names. We split the closing costs with a 3.5% down payment. Afterwards, I paid all future years of the mortgage (including taxes and insurance). It was our primary residence which we then converted to a rental. It was rented only for about 2 years so that we could still quality for the section 121 home sale exclusion and have some extra time to work with. During the years of the house being rented, I have included 100% of the income and expenses (including depreciation) in my personal tax return using Schedule E. My mom doesn't work and doesn't have income. Therefore, she has not filed any tax returns in recent years. We sold the house within the period for us to quality for the home sale exclusion. Sale proceeds of $250K were split with me taking $50K and my mom taking $200K. I filed for an extension to have extra time to work all of these numbers out for the 2023 taxes.
Timeline:
*July 2011 - Home bought for $270K
*Sept 2021 - Primary residence turned into a rental
*Dec 2023 - Rental sold for $450K
General Numbers:
*Original Cost Basis: $258K
*Accumulated Depreciation Taken (in 2021 + 2022): $12K
*Depreciation to be taken in 2023: $9K
*Mortgage balance at time of sale: $175K
*Sales Price: $450K
*Sales Expenses: $27K
*Proceeds: $250K total ($50K for Oscar and $200K for mom)
HERE ARE THE QUESTIONS
1) The home sales exclusion will not exclude the accumulated depreciation taken, correct? We would have to pay taxes on that recapture amount? I'm pretty sure the recapture amount cannot be excluded but wanted to triple check.
2) Since I would be in a high tax bracket for 2023 and my mom will be at the bottom of the tax bracket (no income to be reported), could my mom include 100% of the depreciation recapture in her tax return even though she didn't claim depreciation in the past years when the house was a rental? From what I am reading, the taxpayer who claimed the depreciation expense in the past years is responsible for paying the taxes on the depreciation recapture. But again, I wanted to double check.
3) I believe the best path forward would be for me to report the amount of gain from the sale of the property that is proportional to the proceeds I received and the cost I had to bear. Likewise, my mom would report her share of the gain in her own 2023 tax return. The idea would be that overall, I should not show a gain but a loss that would then be used to offset the depreciation recapture. My mom would show a big gain but she should be able to exclude all of it under the Section 121 home sale exclusion. Would the general approach below make sense? If so, the next step would be to figure out how to actually report it correctly.
Overall Gain from Sale = (Sales Price $450K) - (Sales Expenses $27K) - (Original Cost Basis $258K)
= $165K
Allocation of Sales Proceeds:
Sales Proceeds = $250K (50K or 20% for Oscar & $200K or 80% for mom)
Allocation of Gain (mirroring proportions of sales proceeds):
Gain from Sale = $165K (33K or 20% for Oscar & $132K or 80% for mom)
Allocation of Sales Price - Sales Expenses:
Sales Price - Sales Expenses = $450K - $27K = $423K ($84.6K or 20% for Oscar & $338.4K or 80% for mom)
Allocation of Cost Basis:
Cost Basis = $258K ($129K or 50% for Oscar & $129K or 50% for mom)
Overall Capital Gain/Loss:
Oscar = $84.6K - $129K = -$44.4K
Mom = $338.4K - $129K = $209.4K
Overall Gain = -$44.4K + $209.4K = $165K
For Oscar - The -$44.4K capital loss can be used to offset the $21K depreciation recapture that accumulated up to the sale of the house. The remaining -$23.4K of capital loss can be further reported on Schedule D.
For mom - The $209.4K of capital gain can be offset by the $250K Section 121 home sale exclusion.
*Additional note: The above calculations are based on simply splitting the cost basis in half. However, Oscar actually had to bear more costs after the initial split of closing costs through his 100% payment of the mortgage until the sale of the house. Therefore, there might be a way to calculate a different split of the cost basis where the cost is much higher for Oscar than mom. This approach could further increase Oscar's capital loss and further increase mom's gain.
