how to handle depreciation after sale of rental property with 1031 exchange

[TigerMO]

I sold one rental property (house A) and purchased another one (House B) by a 1031 exchange. House A had some capital improvements that were still being depreciated at the time it was exchanged for House B. Turbotax has had me continuing to claim depreciation on those capital improvements even though I no longer own House A. I don't think that was correct. Since it was a 1031 exchange, can I continue to claim depreciation on improvements on House A that weren't fully depreciated at the time of the exchange for House B? If not, what should I have done in Turbotax to remove those improvements from my Form 4562? In other words, how do I tell Turbotax that those capital improvements on House A were sold with the house? 

Thanks.

[DianeW777 · Accepted solution]

The information you received is correct. The depreciation asset for the property given up in the Section 1031 exchange remains the same without change, including your improvements to the property given up.  It must go forward for the new property as though it is the same real estate (you could rename it). You do not tell TurboTax the improvements were sold.  They are part of the cost of the property received in the trade.

Any additional cash or funds paid in the exchange, above and beyond the property itself, is another and separate, distinct asset with the recovery period of 27.5 years, this can include any improvements to the new property received after the exchange in the year of the exchange.

For future tracking and records this is the simplest and most convenient way to move forward after a Section 1031 real estate exchange with the need to keep records of the actual exchange to show any additional funds paid for the new asset. The new asset will begin the depreciation recovery in the year of the exchange. The asset for the property given up keeps the same character with no changes.

TurboTax can handle this easily and your time factor can be significantly less for your tax return.

[TigerMO]

Thank you @DianeW777 -

That brings me to the second half of the question.

I've now also sold House B, the rental that was acquired through the 1031 exchange. In Turbotax, it asked if I had sold the rental property and I replied Yes. Turbotax filled in the Date Sold on the Disposition Report of the house, but didn't do anything with the land (as a separate asset not subject to depreciation) or with any of the capital improvements either from House B or the capital improvements carried over from House A when it was sold. My Turbotax questions are:

1. If the gross sales price of House B was $200,000 (including house and land), how do I get TT to allocate the sales price between the house and the land for the Disposition Report?
2. For every capital improvement listed on Form 4562, how do I tell TT to dispose of all of them since I'm assuming I can't continue to claim depreciation on property I no longer own?
3. For each of those capital improvements, how do I go about determining the Gross Sales Price and the Basis? I know what their initial cost was, so do I just subtract the accumulated depreciation and that's now the basis? 

Questions #2 and 3 go together. Can I use Easy Step to have it walk me through the disposition of each asset or do I use some worksheet? I think I kind of know what needs to be done, but I'm not sure how to interact with Turbotax to make it happen.

Many thanks. I hope my explanation makes sense.

[DianeW777]

Here are the answers to your questions.

1. First determine the sales price for each asset (normal procedure when there are several assets).

   • To figure out the selling price for each asset:

   1. Take the current basis of each asset against the total combined basis of all of your assets to figure out the sales price for each one; OR 
   2. Determine a fair market value for each asset against the total value of all assets to figure out the sale price for each one. 

   3. If you  made any capital improvements in the year of sale, you should add that as part of your selling expense. 

2. Go through each asset to indicate it was sold and enter the selling price and sales expense for each asset.

3. TurboTax will do the rest as far as determining cost basis, depreciation and report the sales in the appropriate places.

The following steps will help you through the sales process once you have all the figures you need.

1. Start with the Federal tab
2. Click on Income and Expenses
3. Under Your income and expenses, scroll down to
4. Rental properties and royalties, click Edit/Add
5. Do you want to review your rental?, click Yes
6. Under Rent and Royalty Summary, click Edit
7. Click Update to the right of Assets/Depreciation. Do you want to go directly to your asset summary?, click Yes and Continue
8. Click Edit to the right of the assets to be disposed
9. Go through several screens until you get to Tell Us More About This Rental Asset
10. Click on This item was sold…….
11. And continue to answer the questions

See also here for more details.

[TigerMO]

@DianeW777 -

Your explanations are remarkable and very thorough. It's just me that's a little slow in understanding. I'm going to try to re-state what you said using different words to make sure I'm following correctly. I'm good with following your steps for going through Turbotax for the disposition. but the sales price aspect still feels complicated to me. 

• When House A was exchanged for House B, Turbotax calculated the basis for House B based on the cost basis of House A. That's now what TT uses to calculate the depreciation of House B. Right? 
• Each capital improvement on House A (and the land) stayed on Form 4562 with the same Cost as the original expense at the time it was added and each has continued to depreciate over the years (except the land, of course). Some are fully depreciated. Is their selling price now $0? 
• As I'm following through the steps of the sale process in TT, it gets to the page asking for the Sales Price and I'm not understanding #1 or 2 of your answer about the selling price for assets. If I added a capital improvement 10 years ago and it was set to depreciate over 27.5 years, how do I determine either the current basis or the fair market value to come up with the Sales Price of that asset? Is the current basis the original cost minus depreciation? Otherwise, what's a concrete driveway that cost $4000 to install in 2010 worth in 2020? I have no idea.
• How can I determine the separate sale expenses for individual capital improvements? All I know are the sales expenses for the entire real estate sales transaction which includes all assets?
• If I take Sales Price of all the capital improvement assets and add them up, do I subtract that from the gross sales price of the rental house to get the sales price of the house alone to put in TT? For example, if the closing price of the rental was $150,000 and I've determined that the sales prices of all the assets added up to $15,000, does that make the sales price of the rental house #135,000?

I know there's at least one key part of this that I'm not yet comprehending, but it will all make sense once we can figure out what that is. Thanks for your patience in explaining everything. 

[DianeW777]

Use the original cost of each asset listed on depreciation (all belongs to house B now) add those together then divide each one by the combined total to find the percentage of the cost for each asset.  Use that percentage times the sales price and sales expenses to find the selling price/sales expenses for each asset.

Example:  Original Cost (of each asset on your depreciation schedule)

$10,000 Land                = 13.33% 

$50,000 House              = 66.67%

$15,000 Improvements  = 20%

$75,000 Total                 = 100%

Multiply each percentage times the sales price/sales expenses to arrive at each individual sales price/sales expense.

I hope this example provides clarification to enter your sale.

[TigerMO]

@DianeW777 That example helped so much. I think I can do it now.

One last question. I'm seeing conflicting information on what/if any closing costs are tax-deductible. Which ones are?

You've helped me tremendously. Thanks.

[DianeW777 · Accepted solution]

Mortgage interest and property taxes are the only closing costs that are deductible. Check the settlement statement for the prorated share at settlement and then what is actually paid through the end of the year.

[TigerMO]

That's exactly what I had done!! It feels good to find there's something I got right. 

Thanks again for all your help. You're amazing.

[te2021]

@DianeW777  I was wondering if you could help me since I have similar questions to TigerMO.

I sold one rental property (house A in IL on Mar 1, 2020 ) and purchased another one (House B in VA on Mar 8, 2020) through a 1031 exchange, and did not receive any boot.

I am using TurboTax's premier desktop version.

1) I know there are 2 depreciation options and would like to use the option that would allow me to depreciate more of the cost basis each year.  I understand this means I need to continue to depreciate the replacement property according to two separate depreciation schedules.  I was able to get Turbotax to generate the 8824 but Turbotax also automatically calculated the depreciation for House A for the whole year.  I thought depreciation for House A needs to be from Jan 1-Mar 1 and then Mar 8-Dec 31?  Is that a correct understanding? 

2) If the above is correct, i.e., House A is only supposed to depreciate from Jan1-Mar1 and then Mar 8-Dec 31, how do I go about doing so?  I tried calling Turbotax but they said this topic was out of scope for them to support.

3) If (1) is the correct approach, does it mean I need to file IL taxes annually going forward to claim the depreciation for House A?

4) If I did not receive any boot, and reported a loss, do I still need to file IL taxes?

Thanking you in advance for any help.

[DianeW777]

Essentially you are correct, however in a 1031 exchange the depreciation continues on like there was no change in property.  You still want and should have a full year depreciation on the property given up because that asset now becomes the property you received in the exchange. There is no change that you need to make.

As far as the Illinois (IL) return and assuming you are not a resident of IL here are the filing requirement rules. A loss on the exchange would not produce any taxable income and since you no longer own property in IL then it appears you are not required to file in the future.

A nonresident of IL, you must file Form IL-1040 and Schedule NR if

• you earned enough taxable income from Illinois sources to have a tax liability ( i.e., your Illinois base income from Schedule NR, Step 5, Line 46, is greater than your Illinois exemption allowance on Schedule NR, Step 5, Line 50), or
• you want a refund of any Illinois Income Tax withheld in error. You must attach a letter of explanation from your employer.

@te2021

[te2021]

@DianeW777 Thanks for the quick response!  I really appreciate it.

So one final clarification - I am still supposed to claim depreciation for the one week (Mar 1-8, 2020) where I did not own any property at all?  

Thanks again for your help!

[DianeW777]

Yes.  It's like you had no down period with your Section 1031 exchange.

[te2021]

@DianeW777 Thank you very much for all your help!  You're amazing!

[chrisoleary99]

Hello DianeW777, I understand that the original property depreciation continues to depreciate as part of the basis for a property acquired in a 1031 Exchange. What if the new property is a commercial property and the relinquished property was a residential rental house. IRS says I need to go from 27.5 years amort to 39 years amortization. And what if I want to take advantage of a cost segregation study that would allow me to depreciate certain parts of the newly acquired structure over 5 or 15 years?

Can I somehow create a new worksheet where I could input the new amortization periods?

Thanks

Chris