In 2016, my wife moved to the US from the UK and converted her primary residence to a rental property. As many others have posted, I fell into the trap of misreporting the business use percentage of the property for every year we rented it -- six years in all.
The mistake came when I used the step-by-step to fill in the Asset Entry Worksheet for the first time. I answered that No, the home had not been used 100% of the time for business purposes since being acquired in 2008, and selected that we had used it for personal purposes before we started using it for business in 2016. I then (correctly) provided the date, 02/26/2016, that we began using it in a rental business, and in the next box, Percentage of the time used for business in 2016, I (incorrectly) entered 84.43, a number I manually calculated as 309 of 366 days. (I understand now that 100% was the only correct figure to enter here following Conversion to Business Usage, but my 2016 version did not have the prompts here to say "Do not count non-business use days as personal days.") The next screen gave me the allowable depreciation amount, and that was transferred onto the Depreciation & Amortization Schedule, along with the Cost Basis, figured (I guess) on 84.43%. Later on Schedule E, I did not include any personal use days in 2016.
The following year (and each subsequent year) I would open the Asset Entry Worksheet and revisit my elections for our rental property before adding the current year's income and expense information to our tax return. Misinterpreting and then following through of what I thought was the advice from TT (under Why would I change this information?), I did not update the Summary as I now know I should have done. Therefore, year after year, the pre-populated 84.43% business usage figure remained and was fed into (I guess) the depreciation calculation. On Schedule E however, I continued to enter zero personal use days in each year, and deducted all allowable expenses at 100%.
Of the six years we used the house as a rental, we never had a personal use day, and the house was rented or available for rent every day of the year until it went on the market. The rental business turned a profit in two of those years and small to moderate losses in the rest. Our last tenant moved out in August 2021, and due to the slow post-Pandemic economic recovery in the UK, we had no rental prospects the rest of the year, so in early 2022 we decided it was time to exit the rental business. We spent several weeks and thousands of dollars completing all the inspections and structural surveys needed to satisfy the underwriting requirements of UK-based lenders and insurers for approving a mortgage to prospective buyers. Once on the market the house languished for several more weeks, even as we steadily lowered the asking price. Finally we put it up for auction. On the second attempt it sold, generating a gain of about 20% over the acquisition cost that we reported on our Asset Entry Worksheet.
When I began working through our 2022 return, I entered 100% of sale price and expense as the Business Portion to determine capital gains. When I reviewed the information in the Form view, I discovered my error in carrying over less than 100% Business Usage on the prior five years returns. I then tried to manually change the percentage to 100% in the Form view, which led TT to calculate that I was due a refund of approximately the same amount as the tax due I was just showing at 84.43%! Knowing this was a huge error, I investigated further and discovered I had asked the program to calculate a year-over-year variable business use percentage, which TT indicates it is unable to do on the Special Handling Required? screen.
I am not sure how to proceed now. After researching online posts and articles from the TT Community, tax advisors, and IRS publications, my takeaway is that my mistaken 84.43% entry has only had the effect of lowering the Cost Basis and allowable depreciation, which then increased our taxable gain when we sold the property. Where I am getting hung up is how to reconcile it -- specifically how to report the Business Portion of sales price and expense. It seems to me I could report 84.43% of the sales price and expense as Business Portion then report the remaining 15.57% as Miscellaneous Personal Income. This method will actually cause us to pay slightly more tax on the personal income. Or, I could file everything as-is and report 100% of the sales price and expense as the Business Portion. My concern here is if I were to report in that way, but leave the Business Use Percentage line of the Asset Entry Worksheet showing as 84.43%, that might prompt the IRS to go looking for the missing Personal Use gain from the sale of a second home, thereby increasing inquiry and audit risk. Because this property is outside of the US, there was never any counter-reporting of the sale through information returns to the IRS – so they have no other source for this information except our return. Choosing Yes, Requires Special Handling appears to have no immediate effect on the tax due calculation so long as the business usage percentage line still says 84.43%. Do I have to calculate the variable percentage and the tax liability myself, and if so, by what formula? What other options, if any, should I be considering?
