Fix rental cost basis without changing prior year depreciation

[michash2998]

I brought a rental 4 years ago and entered the purchase price of $385k as the cost.  I then added the closing cost of $12k and water heater $2k as additional assets for 27.5 yrs depreciation.  I did NOT update the rental cost basis to include them.  I am selling the rental now and just learnt that these should be included in rental cost basis in order to get the accurate capital gain.  How do I fix the cost basis without affecting previous depreciation?  Thanks 

[Opus 17]

You need to see an accountant, there are some concepts you haven't addressed.

1. The basis of your depreciation is what you actually paid.  This includes the purchase price, and some (but not all) of your closing costs.  Allowable closing costs for a home are listed in publication 523 on page 8.  But since land doesn't depreciate, you have to reduce your depreciation basis by the value of the land.

2. If the hot water heater was part of the property at closing, you don't include it separately, it is part of the overall $385K price.  If you purchased it after you placed the property in service as a rental, you list it as a separate asset with a recovery period of 27.5 years.  However, if the cost is less than $2500, you may qualify for a safe harbor that allows you to deduct it as an expense, rather than taking depreciation.  Expensing the hot water heater is more advantageous because you don't have to recapture depreciation when you sell.

3. To correct prior depreciation, you either have to file amended returns for all those years, or you need to file form 3115, Application for Change in Accounting Method.  This form is not easy to fill out and is not supported by Turbotax.

I suggest you need a professional tax preparer to get you out of this mess so you can correct the prior depreciation and pay the least tax on the sale of the property. 

[Carl]

Since you used the wrong cost basis for 2 or more years for depreciation, amending is not an option. Per IRS Publication 946 at https://www.irs.gov/pub/irs-pdf/p946.pdf on page 14:

The following are examples of a change in method of accounting for depreciation.
• A change from an impermissible method of determining depreciation for depreciable property if the impermissible method was used in two or more consecutively filed tax returns.

So the IRS Form 3115 would need to be used. This form is not simple by any stretch of the imagination, and I highly urge you to seek professional help. This is especially true if your state also taxes personal income.

[michash2998]

I don’t mind filing amended return.  Since I brought the rental in 2018, can I amend for the last 4 years now?  If I amend all prior years, will my cost basis be corrected for entering the sale of this rental I closing in Oct 2022?  Thanks 

[Opus 17]

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@michash2998 wrote:

I don’t mind filing amended return.  Since I brought the rental in 2018, can I amend for the last 4 years now?  If I amend all prior years, will my cost basis be corrected for entering the sale of this rental I closing in Oct 2022?  Thanks 

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Sorry, per @Carl , if the mistake was more than 2 tax returns ago, you can only fix the problem by filing form 3115.

As part of the calculations for form 3115, your accountant will determine your basis and any depreciation recapture that you will use on your 2022 return. 

[michash2998]

To be more precise, 
- tax year 2018, entered purchase price of $385k as cost and started depreciation of just the property portion without land

- tax year 2018, entered closing cost  of $12k as an additional asset and started depreciation

- tax year 2019, brought new water heater of $900 as an additional asset and started depreciation

can I amend tax for the last 4 years to enter the purchase price plus depreciable closing cost as the new cost for year 2018 and start depreciation on that amount excluding land?  

can I amend 2019 tax return to remove the water heater as depreciable asset and enter it as expense instead?

And then amend each subsequent year accordingly?

will the above action provide me with the correct cost basis and amount for depreciation recap when I enter the sale of this rental closing in Oct 2022 with a gain?

 Thanks,

Monita

[Opus 17]

@michash2998 

No.  If you used an impermissible method of depreciation in two or more consecutive years, you must use form 3115.

[tagteam]

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@michash2998 wrote:

- tax year 2018, entered purchase price of $385k as cost and started depreciation of just the property portion without land

- tax year 2018, entered closing cost  of $12k as an additional asset and started depreciation

- tax year 2019, brought new water heater of $900 as an additional asset and started depreciation

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Based solely upon the three statements in the quoted section above, I cannot see an issue that would involve Form 3115. The cost of each asset was, apparently, entered and reported on the tax returns in the years in which they were placed in service and depreciation was deducted.

The only readily apparent issue seems to be that the closing costs were lumped together, listed as an asset, and depreciated separately from the structure rather than having been added to the cost basis of the structure. Perhaps a portion of those costs should have been allocated to the land, but that would be a separate issue.

Regardless, recapture and capital gain should be relatively accurate after the sale provided the correct portion of the sales price is allocated to each asset.

[michash2998]

Yes my depreciation was correct each year and you said the exact thing that my cost structure is now off.  So how to correctly report the sale vs original purchase to have the right amount of capital gain for

- total purchase cost of $397.9k (I.e. $385k + $12k closing + $900 water heater)

- rental sale price of $470k with $35k expense (commission, closing, repairs, etc.)

please advice.  And really thanks for telling me Ai don’t need form 3115.

[Opus 17]

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@michash2998 wrote:

To be more precise, 
- tax year 2018, entered purchase price of $385k as cost and started depreciation of just the property portion without land

- tax year 2018, entered closing cost  of $12k as an additional asset and started depreciation

- tax year 2019, brought new water heater of $900 as an additional asset and started depreciation

can I amend tax for the last 4 years to enter the purchase price plus depreciable closing cost as the new cost for year 2018 and start depreciation on that amount excluding land?  

can I amend 2019 tax return to remove the water heater as depreciable asset and enter it as expense instead?

And then amend each subsequent year accordingly?

will the above action provide me with the correct cost basis and amount for depreciation recap when I enter the sale of this rental closing in Oct 2022 with a gain?

 Thanks,

Monita

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Assuming the above to be true:

- tax year 2018, entered purchase price of $385k as cost and started depreciation of just the property portion without land

- tax year 2018, entered closing cost  of $12k as an additional asset and started depreciation

If you depreciated the building only after subtracting the cost of the land, this is a no harm-no foul error.  Your depreciation would be the same whether you entered the closing costs as part of the house or as a separate asset, since they have the same recovery period.  I agree with @tagteam 

- tax year 2019, brought new water heater of $900 as an additional asset and started depreciation

This is allowable, although you could have taken the safe harbor instead.

can I amend 2019 tax return to remove the water heater as depreciable asset and enter it as expense instead?

And then amend each subsequent year accordingly?

I think is going to be a no, because you changed your mind after more than 2 years, but I am open to alternative interpretations. 

[tagteam]

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@Opus 17 wrote:

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@michash2998 wrote:
can I amend 2019 tax return to remove the water heater as depreciable asset and enter it as expense instead?

And then amend each subsequent year accordingly?

I think is going to be a no, because you changed your mind after more than 2 years, but I am open to alternative interpretations. 

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I agree with @Opus 17 that it would be a "no".

The de minimis safe harbor requires that a statement be attached to a timely filed original federal tax return including extensions for the taxable year in which the de minimis amounts are paid.

See https://www.irs.gov/businesses/small-businesses-self-employed/tangible-property-final-regulations

[Opus 17]

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@tagteam wrote:

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@Opus 17 wrote:

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@michash2998 wrote:
can I amend 2019 tax return to remove the water heater as depreciable asset and enter it as expense instead?

And then amend each subsequent year accordingly?

I think is going to be a no, because you changed your mind after more than 2 years, but I am open to alternative interpretations. 

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I agree with @Opus 17 that it would be a "no".

The de minimis safe harbor requires that a statement be attached to a timely filed original federal tax return including extensions for the taxable year in which the de minimis amounts are paid.

See https://www.irs.gov/businesses/small-businesses-self-employed/tangible-property-final-regulations

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However, it remains the case that @michash2998 does not need to amend and does not need form 3115.  Just prepare and file your return according to the usual rules.  You just have a slight loss on the unfavorable treatment of the hot water heater.  (You probably lost about $200 by depreciating it instead of expensing it.  Not the worst mistake you could have made.)

[tagteam]

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@Opus 17 wrote:
You just have a slight loss on the unfavorable treatment of the hot water heater.  (You probably lost about $200 by depreciating it instead of expensing it.  Not the worst mistake you could have made.)

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That is not a mistake at all at this point. Had the water heater been expensed, the entire amount would now be subject to recapture at ordinary income tax rates upon the sale. The treatment chosen by @michash2998 will result in less recapture if the sales price is allocated accordingly.

[Opus 17]

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@tagteam wrote:

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@Opus 17 wrote:
You just have a slight loss on the unfavorable treatment of the hot water heater.  (You probably lost about $200 by depreciating it instead of expensing it.  Not the worst mistake you could have made.)

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That is not a mistake at all at this point. Had the water heater been expensed, the entire amount would now be subject to recapture at ordinary income tax rates upon the sale. The treatment chosen by @michash2998 will result in less recapture if the sales price is allocated accordingly.

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Isn't the whole point of the safe harbor expense that the item is not an asset but an expense and doesn't have to be recaptured?  We're not talking about section 179 or some other kind of bonus or accelerated depreciation.  See for example here.

https://ttlc.intuit.com/community/investments-and-rental-properties/discussion/are-rental-property-s...

(And lastly note that the safe harbor for small businesses including rental improvements that applies here is a different safe harbor than the $2500 one I was thinking of.  The limit is potentially higher, for one thing.  Doesn't change my answer though.) https://www.irs.gov/businesses/small-businesses-self-employed/tangible-property-final-regulations#Sa...

[tagteam]

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@Opus 17 wrote:
Isn't the whole point of the safe harbor expense that the item is not an asset but an expense and doesn't have to be recaptured?

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No.

See Treas. Reg. §1.263(a)-1(f)(3)(iii))