Fix rental cost basis without changing prior year depreciation

[Mike9241]

@tagteam i thought if you expense using safe harbor there is no depreciation recapture. 

[tagteam]

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@Mike9241 wrote:

@tagteam i thought if you expense using safe harbor there is no depreciation recapture. 

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Read the Reg I cited, @Mike9241. The sale basically results in ordinary income (i.e., it is technically not even recapture, it is ordinary income not subject to self-employment tax but there is no 25% cap; it is taxed at ordinary income tax rates).

[Carl]

When you expense a qualified item under safe harbor, it's not treated as an asset and therefore is not depreciated. Additionally, the cost of the item can not be added to the cost basis either.

Now a water heater falls in a somewhat grey area. As I see it, a water heater does not qualify for safe harbor or for SEC179 or SDA. Since a water heater becomes a physical part of the plumbing system, which itself is a physical part of the structure, it gets classified as residential rental real estate and depreciated over 27.5 years.

There are others who will disagree with my assessment/interpretation, and they most certainly can do so.

[Opus 17]

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@tagteam wrote:

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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))

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There is nothing directly about recapture in that section.   But it does say that safe harbor expenses may not be capitalized.  If it's not capitalized it does not add to the basis, and there is nothing to recapture from.   

IRC section 1245 addresses recapture.  Specifically, 

(2)(A) In general the term “recomputed basis” means, with respect to any property, its adjusted basis recomputed by adding thereto all adjustments reflected in such adjusted basis on account of deductions (whether in respect of the same or other property) allowed or allowable to the taxpayer or to any other person for depreciation or amortization.

Which links to Treasury Regs https://www.law.cornell.edu/cfr/text/26/1.1245-1

In general, the term recomputed basis means the adjusted basis of property plus all adjustments reflected in such adjusted basis on account of depreciation allowed or allowable for all periods after December 31, 1961.

Property expensed under a safe harbor does not result in a recomputed basis because it is an expense, not an adjustment to basis.

But whatever.  

[Opus 17]

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@Carl wrote:

When you expense a qualified item under safe harbor, it's not treated as an asset and therefore is not depreciated. Additionally, the cost of the item can not be added to the cost basis either.

Now a water heater falls in a somewhat grey area. As I see it, a water heater does not qualify for safe harbor or for SEC179 or SDA. Since a water heater becomes a physical part of the plumbing system, which itself is a physical part of the structure, it gets classified as residential rental real estate and depreciated over 27.5 years.

There are others who will disagree with my assessment/interpretation, and they most certainly can do so.

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There are two safe harbors that we might be mixing up.  There is a safe harbor of $2500 for tangible property, I don't think that applies.

However there is also a separate "safe harbor for small taxpayers" which includes improvements to residential real estate.  Plumbing is specifically included. The taxpayer must own less than $10M of real estate to qualify and the safe harbor limit is $10,000 or 2% of the cost basis, whichever is less.  (h)(7) specifies that items with this election are not treated as improvements for tax purposes.

https://www.law.cornell.edu/cfr/text/26/1.263(a)-3

https://www.nolo.com/legal-encyclopedia/small-taxpayer-safe-harbor-for-repairs-improvements.html

[tagteam]

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@Opus 17 wrote:

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@tagteam wrote:

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

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There is nothing directly about recapture in that section.   But it does say that safe harbor expenses may not be capitalized.  If it's not capitalized it does not add to the basis, and there is nothing to recapture from.   

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Once again, it is not recapture. As a result of the expensing of the asset, its basis is reduced to zero ($0).

When the asset is later sold, it is neither capital gain nor Section 1245 gain (recapture). Rather, the sale results in ordinary income.

[michash2998]

Thank you for confirming I don’t need 3115.   I want to know how TurboTax calculate my capital gain. Recap with sales detail:

- 2018 brought rental $385k + $12k closing + $900 w.h.  Each as separate asset and deprecated appropriately from 2018 onward

- 2022 Selling rental for $470k with closing cost, commission, repairs, etc. to $40k.  Closing date will be Oct 2020.  

How will TurboTax calculate my capital gain amount?  Should my capital gain on selling this rental be $470,000 - $40,000 - ($385,000 + $12,000 + $900) = $32,100?

should I amend tax from 2018 to include the closing close of $12k as part of the original rental purchase price in order to get the correct capital gain?

 Thanks 

[Opus 17]

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@tagteam wrote:

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@Opus 17 wrote:

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@tagteam wrote:

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

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There is nothing directly about recapture in that section.   But it does say that safe harbor expenses may not be capitalized.  If it's not capitalized it does not add to the basis, and there is nothing to recapture from.   

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Once again, it is not recapture. As a result of the expensing of the asset, its basis is reduced to zero ($0).

When the asset is later sold, it is neither capital gain nor Section 1245 gain (recapture). Rather, the sale results in ordinary income.

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OK, I see where you are coming from.  That does apply to tangible property under the tangible property safe harbor, I agree completely.

It does not apply to building improvements under the safe harbor for small taxpayers §1.263.

https://www.law.cornell.edu/cfr/text/26/1.263(a)-3

The improvement (in this case, plumbing) becomes part of the building, and is not treated as an improvement for tax purposes. Paragraph (h)(7).  See also example 1 under (h)(10).  The building retains its original basis.  (While a hot water heater is potentially tangible property when you bring it home from the big box store, I believe it becomes real property once installed.  See (e)(2)(B)(2).)

In more detail the rule allows you to treat "repairs, maintenance, improvements, and similar activities" as expenses, as long as the total for such activities is less than the cap. Repairs and maintenance are deductible expenses anyway, the point of the section is to allow you to expense all your "repairs, maintenance, improvements, and similar activities" as long as they don't exceed the cap.  (In other words, small taxpayers are relieved of the burden of keeping separate track of small improvements like a hot water heater or a new deadbolt or new chandelier as long as their total expenses are less than the cap.)  Essentially, if this taxpayer must recapture a $900 water heater, they also have to recapture a doorbell camera, outside security light, deadbolt, toilet, or any other small addition to the property with an expected life of more than 1 year.  And the whole point is, small taxpayers don't have to do that.

[tagteam · Accepted solution]

@michash2998 

Based upon the original figures you posted earlier, it appears as if you have omitted the cost of land from your basis in your latest post. You need to factor that into your equation.

Also note that you cannot deduct "fix-up" expenses as selling expenses.

Further, you will most likely have an unrecaptured Section 1250 gain (depreciation recapture) component as well as a capital gain component. The former is taxed at ordinary income tax rates up to a maximum of 25%.

With respect to the $12k in closing costs that you depreciated separately, that component should be factored into your recapture and gain equation. Since you have be depreciating those costs as a separate component, there is no need to amend and add it to the original cost basis.

[tagteam]

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@Opus 17 wrote:
That does apply to tangible property under the tangible property safe harbor, I agree completely.

It does not apply to building improvements under the safe harbor for small taxpayers §1.263.

https://www.law.cornell.edu/cfr/text/26/1.263(a)-3

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The relevant regulation is Section 1.263(a)-1. 

[tagteam]

@michash2998 

Did you read my previous post?

[michash2998]

I just did and it’s really helpful hence I removed my question above.  Let me digest what you said and see if I have more questions.  Thank you very much.

[michash2998]

Regarding land portion - I had used the land value from the rental’s 2018 property tax bill as the portion not to depreciate.  Is that correct?

The sale closing is Oct and 2 things happened in Aug while we are still renting the unit out till end of Sep:

a.  The AC just broke and we replaced it for $4,500.  Building permit application $100
b.  We just got the water heater certified for $1500 (it was installed by my husband back in 2019 & we only reported cost of buying the w.h.  for depreciation in 2019).  Building permit application $100

what is the best way to report the AC and the water heater cost above for tax year 2022.  Thanks. 

[tagteam]

The actual land value that you assigned in the past is now largely irrelevant since you will be selling the property this year and you have taken depreciation deductions based on the value you assigned to the structure. You need to ensure that you add the land value to your basis.

You can add the cost of the A/C unit to your adjusted basis since it was just replaced recently.

I am not certain what you mean when you stated you got the "water heater certified". Regardless, in TurboTax you will report that asset as "sold" (i.e., if you expensed it, your cost basis is $0 and you will allocate a portion of the sales price to it).