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lkmisc
Returning Member

How to correct original cost basis and prior years depreciation on rental property

My spouse lived in another state for work and bought a loft in a brand new building as a primary residence for $245K in 2007.  In late 2009, he found another job and was able to move back to our home (which is my sole primary residence). He wanted to sell the loft, but that's when the market tanked. The builder filed for bankruptcy and sold the remaining units for around $100K. The values on the lofts never fully recovered and remained under water so no one was willing to sell at a huge loss.  He converted his unit to a fully furnished rental at the very end of 2015. We started the depr schedule in 2016. I think the cost basis used may have been too high ($249,500).  My husband suffers from memory loss and doesn't recall where he got that number from.  Maybe the tax assessment? A couple of units sold in 2017 for $190K.  There had been no sales of any other units prior to 2017, so no comparables and there was nothing else like these units in the small town.

 

The unit was rented completely furnished. The furnishings were depreciated under one line item based on our estimated value of what it was worth. Since then, an IRS agent told us that you can't depreciate furniture, but Turbotax specifically lists it under category F: "Rental appliances, carpeting, furniture", so we thought it was allowable at the time since it was business use. We aren't sure we used the correct valuation either and have no means to prove the value if audited. We looked up the value of similar furnishings online at the time.  We also depreciated the appliances based on what we thought they would cost at the time of conversion.  

 

The loft was just sold (all furniture included in the sale) at the end of 2020 for $225K so a loss since it was purchased for $245K.

 

I know we have to recapture depreciation in 2020, but I'm not sure about any corrections  we might need to make and how to go about doing that.  I know you can only go back and amend 3 years. I still have Turbotax 2017, 2018 and 2019 installed (not 2016)  so can amend if necessary.

 

Does it sound like our cost basis on the property is incorrect? What impact on our taxes would lowering the cost basis have, given that we sold the unit for less than purchased? Our prior returns show substantial losses on this rental from 2016 on.  It was also rented at a monthly loss as he couldn't charge high enough rent to cover the HOA monthly fees nor the entire mortgage payment in that market.

 

Can we depreciate furniture in a fully furnished rental and how does one prove the valuation from the past?

 

Thanks for any advice.

 

 

6 Replies
ThomasM125
Employee Tax Expert

How to correct original cost basis and prior years depreciation on rental property

If you lowered the cost basis, that would reduce your loss on sale which would have a negative affect on your taxable income. You didn't say how the cost of the property was determined, so I can't comment on whether you entered the correct cost or not.

 

You can depreciate furniture and fixtures used in a rental activity.

 

You can file form 3115 to report depreciation missed in previous years as one lump sum on your current year tax return. You will have to calculate what the missed depreciation was to make the adjustment though.

 

Here is how you do the entries for form 3115 in the desktop version of TurboTax:

 

Attach form 3115 to the tax return for the year of the change, along with a statement describing the property subject to the change. Include the year the property was placed in service and the property’s use in the applicant’s trade, business or income-producing activity.

Review questions 5 – 7 for additional disclosure requirements.  Mail a copy of form 3115 and the disclosure statement to the address in the instructions to form 3115.

You enter the adjustment referenced as section 481(a) depreciation adjustment in the “Other Expense” section on your schedule E, page 1 or on form 8825 if for a partnership or S corporation rental activity.

 

Here's a link to the IRS information on form 3115:

 

https://www.irs.gov/forms-pubs/about-form-3115

 

 

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Carl
Level 15

How to correct original cost basis and prior years depreciation on rental property

Here's a synopsis based on what I can figure out from all the information provided.

-Property purchased in 2007 for $245,000

-Property placed "in service" as a rental in 2016 using a cost basis of $249,000 for depreciation.

The problem at this point, is that in the year of conversion to rental, the cost basis for depreciation is the "lower" of a) what you paid for it when originally purchased or b) It's FMV on the date of conversion. So an incorrect and invalid cost basis was used in 2016 upon converting the property to a rental. It's not really a lot. Normally, I wouldn't be concerned with it. However, the hosing market tanked starting in the 2008-2009 time frame. So having used a higher cost basis "may" stick out with the IRS for all I know.

 

The statement, "A couple of units sold in 2017 for $190K" supports my statement that a significantly lower cost basis "should" have been used in 2016 when the property was converted to a rental. But it wasn't. So it is what it is. In my opinion (and we all know what opinions are like) this needs to be corrected and fixed. 

 

Next is the statement "an IRS agent told us that you can't depreciate furniture"
There was probably a miscommunication between you and the IRS, as the IRS agent's information is wrong, and while not impossible, I would not think an actual employee of the IRS would have told you that in the context presented in your post. But then, I've heard stories of worse, more inaccurate information coming directly from the IRS.

 

At this point, I would highly recommend you seek professional help. Especially since the filing deadline is almost just around the corner. The proper way to fix this situation is to include the IRS Form 3115 - Change In Accounting Method form with your 2020 tax filing, to correct the depreciation. While this form is included with the TurboTax program, it's not simple by any stretch. Especially since you have depreciation mistakes on multiple assets. (property and furniture). On top of that, if your state taxes personal income this "could" turn into a double-whammy.

 

A tax professional in your local area can help you "make things right" and may be able to keep your back taxes if any, along with any penalties and fines that may be assessed for incorrect reporting in the past, to a minimum. For all we know, they may be able to eliminate fines/penalties entirely. Therefore it's my recommendation you seek professional help on this and have a professional that is well experienced with tax laws not just at the federal level, but at the state level also.

When you go this route, once all is said and done make sure the professional provides you with a complete copy of your return, to include all worksheets and calculation forms. You will need the data for your 2021 taxes next year, if you decide to use TurboTax. You can't import from whatever the tax professional may provide you. So you'll have to enter any and all historical date (if it applies) manually, yourself.

lkmisc
Returning Member

How to correct original cost basis and prior years depreciation on rental property

Thank you very much for the detailed response.

 

The sales of other units were in 2017, so there was no data to use in the prior year when it was converted. Allowing for a meager $5K of appreciation over a 9 year period doesn't seem unreasonable even with the market drop of 2008/2009 since the conversion was 7-8 years after the drop. Hindsight is 20/20, but we weren't aware of those prior sales until  2020 when the realtor listing the property pulled up prior sales to determine the listing price. 

 

I don't know what documentation would be required to "prove" that 2016 valuation other than what I just stated was apparently a very conservative and reasonable estimate of value. 

 

In hiring a CPA, how would he/she come up with the value of the furnishings and appliances to determine whether the original values used were too high? I don't know what sort of documentation would need to be provided, as none exists.  The property was never anticipated to be turned into a rental when it was purchased so no receipts exist.

gloriah5200
Employee Tax Expert

How to correct original cost basis and prior years depreciation on rental property

You can get records from the local taxing authority regarding the purchase price of the property when he first purchased it.  Your local real estate tax records may be acceptable for determining fmv on the date of rental.

 

The correct way of determining the depreciable basis of a rental property that used to be a principal residence is to use the lesser of fmv at the time you are turning it into a rental or the adjusted basis. 

 

From your details above, it seems that a smaller amount should have been used if the property values had declined.  It seems that the amount he determined to be the depreciable basis may have been your adjusted basis of the cost of the property + certain closing costs.

 

If a property is rented furnished it is okay to depreciate the furniture in it, as long as the same method is used...if it was prior personal use and now placed in service as rental property, the depreciable basis should be the lesser of fmv or adjusted basis at the time the property was changed from personal use to a rental property.

 

Since you realized this year that things were not handled correctly, the steps you should take are to use Form 3115, Change in Accounting Method to make the adjustment for the excess depreciation taken and to place it in service using the correct amounts.

 

You will have to purchase a desktop version of TurboTax for Form 3115 and, basically, start over with that version.

 

However, even with the desktop versions, Form 3115 generally needs to be prepared in Forms Mode (there is virtually no guidance in terms of making entries). As a result, you might be better advised to seek guidance from a tax professional to prepare this form.

 

Since the fmv is now less than the adjusted basis, then when the property is sold you will actually use the correct adjusted basis less depreciation allowed or allowable vs the selling price.

 

For additional information, please refer to IRS publication 527:

Basis of Property Changed to Rental Use

When you change property you held for personal use to rental use (for example, you rent your former home), the basis for depreciation will be the lesser of the fair market value or adjusted basis on the date of conversion.

 

Fair market value.

This is the price at which the property would change hands between a willing buyer and a willing seller, neither having to buy or sell, and both having reasonable knowledge of all the relevant facts.

 

Sales of similar property, on or about the same date, may be helpful in figuring the fair market value of the property.

 

Figuring the basis.

The basis for depreciation is the lesser of:

• The fair market value of the property on the date you changed it to rental use; or

• Your adjusted basis on the date of the change—that is, your original cost or other basis of the property, plus the cost of permanent additions or improvements since you acquired it, minus deductions for any casualty or theft losses claimed on earlier years' income tax returns and other decreases to basis. For other increases and decreases to basis, see Adjusted Basis in chapter 2.

 

IRS Publication 527

Carl
Level 15

How to correct original cost basis and prior years depreciation on rental property

Just some clarification here.

Your local real estate tax records may be acceptable for determining fmv on the date of rental.

There is a difference between the tax value, and the fair market value. Understand that you can not use the tax value, as that is traditionally 30% or more, below the fair market value. If you do use the tax value as the cost basis, then you best make sure that is "the" only value available that can be proven.

Lately I've noticed on some tax bills that they include both the FMV and the separate tax value. How the property tax appraiser comes up with an FMV on the property with a structure on it is beyond me, since the property tax appraiser never steps foot inside any structures on that property.

lkmisc
Returning Member

How to correct original cost basis and prior years depreciation on rental property

I'm glad you chimed in about the taxable value and how it's not always market value. It currently shows an assessed value of $133K.  So, that is not going to be of use. 

 

I still don't comprehend the documentation I need for FMV.  As an example, if I am coming up with the FMV of the furniture, it is my best estimation of what it is worth. Unless I have everything officially appraised which would produce an official document showing the value, there is nothing on paper. There is no Kelley Blue Book or other valuation guide that I can point to in coming up with the value. So what proof does anyone use to paper the file?  It was high end furniture and using thrift store pricing would not have been accurate. And, hypothetically, if it was low end furniture and thrift store pricing was used, there would be no price list from the thrift store showing the comparable furniture pricing. So, it's basically my word.  If the IRS says prove the value, what do people produce to "prove" the FMV? 

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