How to report adjusted basis of rental property?

[fgao625]

I purchased a townhouse at $370,000 in 2005 for personal living, then converted it to rental property in 2013. The property's assessment value is $240,000 (land $60,000, building $180,000) in 2013. Is it correct to use $180,000 as adjusted basis for the rental property?

[DDollar]

If you paid $370,000 that is your cost basis. If the property had declined in value when you placed it in service as a rental, you have the option to use either your cost basis or the current value when placed in service.  Tax assessments are not a good way to determine value, as they usually are not accurate.   A better determination of value would be to look at comp sales made around that time. 

What the property tax assessment is good for is to allocate your cost basis between land and improvements.  So, if you used the ratio of your assessment to allocate your $370,000 cost basis as $92,500 for land and $277,500 for the improvements (building).

[fgao625]

Thank you for your answer! Unfortunately, I already used $180,000 as the adjusted basis of my rental property in 2013 and had depreciated on this basis ($180,000) since then. Now the FMV is still less than its original purchase price ($370,000). If I sell the rental property this year for $300,000, which basis should I use to calculate gain/loss? Use the original cost ($370,000) or the adjusted basis $240,000 (building $180,000 and land $60,000)?

[DDollar]

Your cost basis is what you paid for the property ($370,000), plus improvements, less depreciation.  You will have two separate transactions to report: the land and the building (and if you capitalized any improvements to the property you'll have a transaction for each on those).  You will have to allocate the proceeds between the land, the building and if applicable the capitalized improvements.

[fgao625]

Thank you so much! It's all clear now.

[DDollar]

You're welcome.  I'm glad I was able to be of help.

[hockeyweasel]

I disagree with DDollar.

In IRS Publication 551 it states:

[removed]

If you hold property for personal use and then change it to business use or use it to produce rent, you must figure its basis for depreciation. An example of changing property held for personal use to business use would be renting out your former main home.

Basis for depreciation.

The basis for depreciation is the lesser of the following amounts.

• The FMV of the property on the date of the change, or

• Your adjusted basis on the date of the change.

The adjusted basis is the price you paid, plus improvements and certain closing costs.  The FMV could be higher or lower.  But this also means that using the assessed value wasn't quite right, either (this is the mistake that I made when I converted my main home, purchased at $250,000 to a rental property, which had a FMV of $235,000). Use the assessed value of the structure and the land to figure out their percentage of the cost.  In my case, the assessed value of my real property was $225,880 of which $70,000 was land(!), so I should have used the 69% ($155,880) on the FMV at the time to get my starting basis for depreciation.  

I saw somewhere that the statute of limitations is 3 years (maybe the limit on amending prior year tax returns?) so I think it's too late to go in and fix it.  

The downside is that with depreciation from a lower starting cost, when you sell it's likely to look like you have a capital gain, plus that depreciation recapture.  My capital gain looked at least $10,000 higher than it should have been.  However, keep track of your Schedule E, line 26. If you have losses, they carryover until they cancel out gains or you dispose of the property, at which point the PAL reduces your taxable income.