Fix rental cost basis without changing prior year depreciation

You need to see an accountant, there are some concepts you haven't addressed.

1. The basis of your depreciation is what you actually paid.  This includes the purchase price, and some (but not all) of your closing costs.  Allowable closing costs for a home are listed in publication 523 on page 8.  But since land doesn't depreciate, you have to reduce your depreciation basis by the value of the land.

2. If the hot water heater was part of the property at closing, you don't include it separately, it is part of the overall $385K price.  If you purchased it after you placed the property in service as a rental, you list it as a separate asset with a recovery period of 27.5 years.  However, if the cost is less than $2500, you may qualify for a safe harbor that allows you to deduct it as an expense, rather than taking depreciation.  Expensing the hot water heater is more advantageous because you don't have to recapture depreciation when you sell.

3. To correct prior depreciation, you either have to file amended returns for all those years, or you need to file form 3115, Application for Change in Accounting Method.  This form is not easy to fill out and is not supported by Turbotax.

I suggest you need a professional tax preparer to get you out of this mess so you can correct the prior depreciation and pay the least tax on the sale of the property. 

Since you used the wrong cost basis for 2 or more years for depreciation, amending is not an option. Per IRS Publication 946 at https://www.irs.gov/pub/irs-pdf/p946.pdf on page 14:

The following are examples of a change in method of accounting for depreciation.
• A change from an impermissible method of determining depreciation for depreciable property if the impermissible method was used in two or more consecutively filed tax returns.

So the IRS Form 3115 would need to be used. This form is not simple by any stretch of the imagination, and I highly urge you to seek professional help. This is especially true if your state also taxes personal income.

I don’t mind filing amended return.  Since I brought the rental in 2018, can I amend for the last 4 years now?  If I amend all prior years, will my cost basis be corrected for entering the sale of this rental I closing in Oct 2022?  Thanks 

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@michash2998 wrote:

I don’t mind filing amended return.  Since I brought the rental in 2018, can I amend for the last 4 years now?  If I amend all prior years, will my cost basis be corrected for entering the sale of this rental I closing in Oct 2022?  Thanks 

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Sorry, per @Carl , if the mistake was more than 2 tax returns ago, you can only fix the problem by filing form 3115.

As part of the calculations for form 3115, your accountant will determine your basis and any depreciation recapture that you will use on your 2022 return. 

To be more precise, 
- tax year 2018, entered purchase price of $385k as cost and started depreciation of just the property portion without land

- tax year 2018, entered closing cost  of $12k as an additional asset and started depreciation

- tax year 2019, brought new water heater of $900 as an additional asset and started depreciation

can I amend tax for the last 4 years to enter the purchase price plus depreciable closing cost as the new cost for year 2018 and start depreciation on that amount excluding land?  

can I amend 2019 tax return to remove the water heater as depreciable asset and enter it as expense instead?

And then amend each subsequent year accordingly?

will the above action provide me with the correct cost basis and amount for depreciation recap when I enter the sale of this rental closing in Oct 2022 with a gain?

 Thanks,

Monita

@michash2998 

No.  If you used an impermissible method of depreciation in two or more consecutive years, you must use form 3115.

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@michash2998 wrote:

- tax year 2018, entered purchase price of $385k as cost and started depreciation of just the property portion without land

- tax year 2018, entered closing cost  of $12k as an additional asset and started depreciation

- tax year 2019, brought new water heater of $900 as an additional asset and started depreciation

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Based solely upon the three statements in the quoted section above, I cannot see an issue that would involve Form 3115. The cost of each asset was, apparently, entered and reported on the tax returns in the years in which they were placed in service and depreciation was deducted.

The only readily apparent issue seems to be that the closing costs were lumped together, listed as an asset, and depreciated separately from the structure rather than having been added to the cost basis of the structure. Perhaps a portion of those costs should have been allocated to the land, but that would be a separate issue.

Regardless, recapture and capital gain should be relatively accurate after the sale provided the correct portion of the sales price is allocated to each asset.

Yes my depreciation was correct each year and you said the exact thing that my cost structure is now off.  So how to correctly report the sale vs original purchase to have the right amount of capital gain for

- total purchase cost of $397.9k (I.e. $385k + $12k closing + $900 water heater)

- rental sale price of $470k with $35k expense (commission, closing, repairs, etc.)

please advice.  And really thanks for telling me Ai don’t need form 3115.

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@michash2998 wrote:

To be more precise, 
- tax year 2018, entered purchase price of $385k as cost and started depreciation of just the property portion without land

- tax year 2018, entered closing cost  of $12k as an additional asset and started depreciation

- tax year 2019, brought new water heater of $900 as an additional asset and started depreciation

 

can I amend tax for the last 4 years to enter the purchase price plus depreciable closing cost as the new cost for year 2018 and start depreciation on that amount excluding land?  

 

can I amend 2019 tax return to remove the water heater as depreciable asset and enter it as expense instead?

 

And then amend each subsequent year accordingly?

 

will the above action provide me with the correct cost basis and amount for depreciation recap when I enter the sale of this rental closing in Oct 2022 with a gain?

 

 Thanks,

Monita

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Assuming the above to be true:

- tax year 2018, entered purchase price of $385k as cost and started depreciation of just the property portion without land

- tax year 2018, entered closing cost  of $12k as an additional asset and started depreciation

If you depreciated the building only after subtracting the cost of the land, this is a no harm-no foul error.  Your depreciation would be the same whether you entered the closing costs as part of the house or as a separate asset, since they have the same recovery period.  I agree with @Anonymous_ 

- tax year 2019, brought new water heater of $900 as an additional asset and started depreciation

This is allowable, although you could have taken the safe harbor instead.

can I amend 2019 tax return to remove the water heater as depreciable asset and enter it as expense instead?

And then amend each subsequent year accordingly?

I think is going to be a no, because you changed your mind after more than 2 years, but I am open to alternative interpretations. 

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@Opus 17 wrote:

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@michash2998 wrote:
can I amend 2019 tax return to remove the water heater as depreciable asset and enter it as expense instead?

And then amend each subsequent year accordingly?

I think is going to be a no, because you changed your mind after more than 2 years, but I am open to alternative interpretations. 

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I agree with @Opus 17 that it would be a "no".

The de minimis safe harbor requires that a statement be attached to a timely filed original federal tax return including extensions for the taxable year in which the de minimis amounts are paid.

See https://www.irs.gov/businesses/small-businesses-self-employed/tangible-property-final-regulations

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@Anonymous_ wrote:

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@Opus 17 wrote:

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@michash2998 wrote:
can I amend 2019 tax return to remove the water heater as depreciable asset and enter it as expense instead?

And then amend each subsequent year accordingly?

I think is going to be a no, because you changed your mind after more than 2 years, but I am open to alternative interpretations. 

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I agree with @Opus 17 that it would be a "no".

 

The de minimis safe harbor requires that a statement be attached to a timely filed original federal tax return including extensions for the taxable year in which the de minimis amounts are paid.

 

See https://www.irs.gov/businesses/small-businesses-self-employed/tangible-property-final-regulations

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However, it remains the case that @michash2998 does not need to amend and does not need form 3115.  Just prepare and file your return according to the usual rules.  You just have a slight loss on the unfavorable treatment of the hot water heater.  (You probably lost about $200 by depreciating it instead of expensing it.  Not the worst mistake you could have made.)

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@Opus 17 wrote:
You just have a slight loss on the unfavorable treatment of the hot water heater.  (You probably lost about $200 by depreciating it instead of expensing it.  Not the worst mistake you could have made.)

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That is not a mistake at all at this point. Had the water heater been expensed, the entire amount would now be subject to recapture at ordinary income tax rates upon the sale. The treatment chosen by @michash2998 will result in less recapture if the sales price is allocated accordingly.

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@Anonymous_ wrote:

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@Opus 17 wrote:
You just have a slight loss on the unfavorable treatment of the hot water heater.  (You probably lost about $200 by depreciating it instead of expensing it.  Not the worst mistake you could have made.)

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That is not a mistake at all at this point. Had the water heater been expensed, the entire amount would now be subject to recapture at ordinary income tax rates upon the sale. The treatment chosen by @michash2998 will result in less recapture if the sales price is allocated accordingly.

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Isn't the whole point of the safe harbor expense that the item is not an asset but an expense and doesn't have to be recaptured?  We're not talking about section 179 or some other kind of bonus or accelerated depreciation.  See for example here.

https://ttlc.intuit.com/community/investments-and-rental-properties/discussion/are-rental-property-safe-harbor-election-expenditures-subject-to-depreciation-recapture-when-the/00/441767

(And lastly note that the safe harbor for small businesses including rental improvements that applies here is a different safe harbor than the $2500 one I was thinking of.  The limit is potentially higher, for one thing.  Doesn't change my answer though.) https://www.irs.gov/businesses/small-businesses-self-employed/tangible-property-final-regulations#SafeHarborElectionforSmallTaxpayers

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@Opus 17 wrote:
Isn't the whole point of the safe harbor expense that the item is not an asset but an expense and doesn't have to be recaptured?

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No.

See Treas. Reg. §1.263(a)-1(f)(3)(iii))

@Anonymous_ i thought if you expense using safe harbor there is no depreciation recapture. 

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@Mike9241 wrote:

@Anonymous_ i thought if you expense using safe harbor there is no depreciation recapture. 

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Read the Reg I cited, @Mike9241. The sale basically results in ordinary income (i.e., it is technically not even recapture, it is ordinary income not subject to self-employment tax but there is no 25% cap; it is taxed at ordinary income tax rates).

When you expense a qualified item under safe harbor, it's not treated as an asset and therefore is not depreciated. Additionally, the cost of the item can not be added to the cost basis either.

Now a water heater falls in a somewhat grey area. As I see it, a water heater does not qualify for safe harbor or for SEC179 or SDA. Since a water heater becomes a physical part of the plumbing system, which itself is a physical part of the structure, it gets classified as residential rental real estate and depreciated over 27.5 years.

There are others who will disagree with my assessment/interpretation, and they most certainly can do so.

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@Anonymous_ wrote:

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@Opus 17 wrote:
Isn't the whole point of the safe harbor expense that the item is not an asset but an expense and doesn't have to be recaptured?

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No.

 

See Treas. Reg. §1.263(a)-1(f)(3)(iii))

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There is nothing directly about recapture in that section.   But it does say that safe harbor expenses may not be capitalized.  If it's not capitalized it does not add to the basis, and there is nothing to recapture from.   

IRC section 1245 addresses recapture.  Specifically, 

(2)(A) In general the term “recomputed basis” means, with respect to any property, its adjusted basis recomputed by adding thereto all adjustments reflected in such adjusted basis on account of deductions (whether in respect of the same or other property) allowed or allowable to the taxpayer or to any other person for depreciation or amortization.

Which links to Treasury Regs https://www.law.cornell.edu/cfr/text/26/1.1245-1

In general, the term recomputed basis means the adjusted basis of property plus all adjustments reflected in such adjusted basis on account of depreciation allowed or allowable for all periods after December 31, 1961.

Property expensed under a safe harbor does not result in a recomputed basis because it is an expense, not an adjustment to basis.

But whatever.  

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@Carl wrote:

When you expense a qualified item under safe harbor, it's not treated as an asset and therefore is not depreciated. Additionally, the cost of the item can not be added to the cost basis either.

Now a water heater falls in a somewhat grey area. As I see it, a water heater does not qualify for safe harbor or for SEC179 or SDA. Since a water heater becomes a physical part of the plumbing system, which itself is a physical part of the structure, it gets classified as residential rental real estate and depreciated over 27.5 years.

There are others who will disagree with my assessment/interpretation, and they most certainly can do so.

 

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There are two safe harbors that we might be mixing up.  There is a safe harbor of $2500 for tangible property, I don't think that applies.

However there is also a separate "safe harbor for small taxpayers" which includes improvements to residential real estate.  Plumbing is specifically included. The taxpayer must own less than $10M of real estate to qualify and the safe harbor limit is $10,000 or 2% of the cost basis, whichever is less.  (h)(7) specifies that items with this election are not treated as improvements for tax purposes.

https://www.law.cornell.edu/cfr/text/26/1.263(a)-3

https://www.nolo.com/legal-encyclopedia/small-taxpayer-safe-harbor-for-repairs-improvements.html

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@Opus 17 wrote:

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@Anonymous_ wrote:

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See Treas. Reg. §1.263(a)-1(f)(3)(iii))

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There is nothing directly about recapture in that section.   But it does say that safe harbor expenses may not be capitalized.  If it's not capitalized it does not add to the basis, and there is nothing to recapture from.   

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Once again, it is not recapture. As a result of the expensing of the asset, its basis is reduced to zero ($0).

When the asset is later sold, it is neither capital gain nor Section 1245 gain (recapture). Rather, the sale results in ordinary income.

Thank you for confirming I don’t need 3115.   I want to know how TurboTax calculate my capital gain. Recap with sales detail:

- 2018 brought rental $385k + $12k closing + $900 w.h.  Each as separate asset and deprecated appropriately from 2018 onward

- 2022 Selling rental for $470k with closing cost, commission, repairs, etc. to $40k.  Closing date will be Oct 2020.  

How will TurboTax calculate my capital gain amount?  Should my capital gain on selling this rental be $470,000 - $40,000 - ($385,000 + $12,000 + $900) = $32,100?

should I amend tax from 2018 to include the closing close of $12k as part of the original rental purchase price in order to get the correct capital gain?

 Thanks 

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@Anonymous_ wrote:

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@Opus 17 wrote:

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@Anonymous_ wrote:

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See Treas. Reg. §1.263(a)-1(f)(3)(iii))

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There is nothing directly about recapture in that section.   But it does say that safe harbor expenses may not be capitalized.  If it's not capitalized it does not add to the basis, and there is nothing to recapture from.   

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Once again, it is not recapture. As a result of the expensing of the asset, its basis is reduced to zero ($0).

 

When the asset is later sold, it is neither capital gain nor Section 1245 gain (recapture). Rather, the sale results in ordinary income.

 

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OK, I see where you are coming from.  That does apply to tangible property under the tangible property safe harbor, I agree completely.

It does not apply to building improvements under the safe harbor for small taxpayers §1.263.

https://www.law.cornell.edu/cfr/text/26/1.263(a)-3

The improvement (in this case, plumbing) becomes part of the building, and is not treated as an improvement for tax purposes. Paragraph (h)(7).  See also example 1 under (h)(10).  The building retains its original basis.  (While a hot water heater is potentially tangible property when you bring it home from the big box store, I believe it becomes real property once installed.  See (e)(2)(B)(2).)

In more detail the rule allows you to treat "repairs, maintenance, improvements, and similar activities" as expenses, as long as the total for such activities is less than the cap. Repairs and maintenance are deductible expenses anyway, the point of the section is to allow you to expense all your "repairs, maintenance, improvements, and similar activities" as long as they don't exceed the cap.  (In other words, small taxpayers are relieved of the burden of keeping separate track of small improvements like a hot water heater or a new deadbolt or new chandelier as long as their total expenses are less than the cap.)  Essentially, if this taxpayer must recapture a $900 water heater, they also have to recapture a doorbell camera, outside security light, deadbolt, toilet, or any other small addition to the property with an expected life of more than 1 year.  And the whole point is, small taxpayers don't have to do that.

@michash2998 

Based upon the original figures you posted earlier, it appears as if you have omitted the cost of land from your basis in your latest post. You need to factor that into your equation.

Also note that you cannot deduct "fix-up" expenses as selling expenses.

Further, you will most likely have an unrecaptured Section 1250 gain (depreciation recapture) component as well as a capital gain component. The former is taxed at ordinary income tax rates up to a maximum of 25%.

With respect to the $12k in closing costs that you depreciated separately, that component should be factored into your recapture and gain equation. Since you have be depreciating those costs as a separate component, there is no need to amend and add it to the original cost basis.

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@Opus 17 wrote:
That does apply to tangible property under the tangible property safe harbor, I agree completely.

 

It does not apply to building improvements under the safe harbor for small taxpayers §1.263.

https://www.law.cornell.edu/cfr/text/26/1.263(a)-3

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The relevant regulation is Section 1.263(a)-1.