Garage apartment rented for a number of years then converted to personal use

[RMB_68]

We have a garage apartment as part of our primary residence.  It has been rented (or held for rent) since we bought the property (6+ years).  We plan to rent for a few more years than anticipate one of our kids using it at below market rent (so personal use) or keeping it for guests.   We are currently allocating expenses to the apartment and taking depreciation.  What happens when it is no longer rental property?  I assume there will be depreciation recapture, but how will that work?  Do we simply adjust the basis of our primary residence in total when we eventually sell?

[Mike9241]

What happens when it is no longer rental property? I assume there will be depreciation recapture, but how will that work? Do we simply adjust the basis of our primary residence in total when we eventually sell?

the depreciation allowed or allowable is recaptured when the property is sold. 

if the garage apartment is not within the same dwelling unit as the residential part of the home, the sales price sales expenses, and basis need to be allocated between the two. the garage portion does not qualify for the home sale exclusion.

[RMB_68]

Thank you.  So at the time we stop renting the property, we would need to determine a way to establish FMV for the rental unit.  In order to do that, we'd need to determine the FMV of the entire property and allocate that to the rental unit.  At the time of future sale of the entire property, this FMV would be used to allocate selling expenses and would be the basis for the calculation of g/l for that unit?  Or does a further allocation need to be made to not only allocate expenses to the garage apt vs the rest of the property but also to the period of rental vs nonrental?

[GeorgeM777]

Assuming that you have been taking depreciation against the garage apartment for the period of years that the unit has been rented, the fair market value of the unit may not be that relevant in terms of how you should treat the unit if you decide to sell the entire property in the future.  Presumably, when you started taking depreciation against the unit, you already established a basis (cost) for that unit (either using the lesser of the actual cost or the fair market value).  Now, if you sell the property, the depreciation you took will play a role in the amount of taxes you will have to pay.  Because depreciation expenses lower your cost basis in the property, they ultimately determine your gain or loss when you sell.

If you have held the unit for at least a year, and it appears that you have, and sell it for a profit, you’ll pay long-term capital gain taxes. Depending on your income level, the tax rate is 0%, 15%, or 20% for 2021. If you’re a higher-income taxpayer, you may also have to pay the net investment tax of 3.8%.  

The IRS remembers all those depreciation deductions and they’ll want some of that money back. That's what depreciation recapture does. This is based on your ordinary income tax rate and is capped at 25%. It applies to the portion of the gain attributable to the depreciation deductions you’ve already taken. You report depreciation recapture on IRS Form 4797, Sales of Business Property.

[Hal_Al]

Q. Do we simply adjust the basis of our primary residence in total when we eventually sell?

A. Yes, but not exactly. You do nothing more than note the amount of depreciation previously claimed for future use (when you sell it  in the future).

[RMB_68]

Let's say the original property was purchased Year 1 for $500k and the split between personal and rental unit is 90/10 so $450k to main house $50k garage apt.  We rent for years 1-10 and take depreciation of $20k (just trying to keep round numbers).  We stop renting in year 11 and sell the property in year 20 for $600k.  Is there a g/l calculation for the garage apt or is it simply recapture of the previous depreciation?  

[Hal_Al]

There a gain/loss calculation for the garage apt in addition to recapture of the previous depreciation. In your example, 9/20 of  10%  of the gain would be attributed to your primary residence gain and 11/20 of 10% to rental use.

TurboTax can basically handle this, although some manual  calculation may be needed.  Put off worrying about it until year 20. 

[RMB_68]

LOL - trying to get a good idea of the treatment while the brain isn't completely addled!  

Ok, so it is a combination of years in service and recapture.  Seems a bit harsh though to pay capital gain on the appreciation from year 11 to year 20.  

[Hal_Al]

You don't actually pay capital gain on the appreciation from year 11 to year 20.  You pay on the gain from year 1 to year 11.  But you have to do it on a percentage basis, even if the 20 year gain is not straight line.