Renovation, Refinance and Sale of Rental Property

[NavyDavey2017]

I would be grateful for any assistance with rules relating to the following, as well as advice on how to enter into Turbo Tax Home & Business edition.

In 2018 we purchased a home to use as a rental property.  Our purchase price was about $220,000, and we needed to spend another $80,000 to make it livable for a tenant.  We rented for 3+ years, and our last tenant had the plumbing back up and continued to use toilets, creating extensive sewage damage on both floors and crawl space; which made the home inhabitable as well as in need of major remediation and repairs. The tenants moved out in March 2022, and we began demolition expecting to repair just the damage and put on the rental market again.  But during demolition of impacted areas, we found termite damage, structural issues and other rot that had been hidden by prior owner's remodeling effort. This resulted in decision to perform a to the studs renovation (home was constructed in 1920, so it had poor wiring, no insulation, etc.) in which we spent another $310,000. This work seems to be treated as "restoration" by the tax code.

Once the restoration was nearly complete, we refinanced the original mortgage in order to pay off short term construction loans.  With the increased interest rate, and much larger mortgage, we were unable to find suitable tenants willing to pay the monthly rent we would need to come close to break even on monthly cash flow; so we opted to sell the home rather than continue trying to rent. The home sold in October 2023 at a significant loss, for $475,000.

Major questions include:

1. Is it accurate that we can treat as a rental property up until the point it was sold, since we never converted for personal use?

2. I spent 925 hours working on the house in 2023 as we finalized renovations and got it ready for rent or sale. Does this qualify as "materially participating for more than 750 hours in this business"; even though it was ultimately not rented again?  Since I was also employed, this does not quite represent 50% of my work related time; so it seems I cannot qualify as a Real Estate Professional. 

3. Can we deduct expenses related to the mortgage refinance?  

4. Where do I enter the costs / related details for the restoration expense? I entered as Repairs under Business / Common Expenses. Is this correct? I have read that major capital improvements should be depreciated over multiple years, but we sold the home, so I am unclear on how to calculate the cost basis.  For example, should we include the purchase price + original capital improvements of $80,000 + the restoration expense of $310,000.

5. Where do I enter details of the sale of the house? Related to this, will TurboTax automatically account for depreciation of prior years (2018 - 2022)?

6. Based on the time spent working on the home in 2023, is the QBI safe harbor applicable?

Thank you!

[MarilynG1]

It sounds like the property was 'unrentable' during renovations, so no, you converted it to personal use as soon as it was no longer available for rent (March 2022).  You're correct, you wouldn't qualify as a RE pro.

There's no advantage to keeping it as rental property anyway, since the major improvements you did are all going to be added to the Cost Basis, as will be your refinancing costs and any other sales costs you incurred. 

Your selling Cost Basis would be the original Cost Basis when you started renting, 300K (220K you paid, plus 80K improvements), plus the Cost of Improvements done before sale (you said 310K, plus Sales Expenses, less Depreciation Taken (which you can find on the last tax return where you reported rental income/expense), Form 4562.  Add Prior Depreciation and Current Depreciation together for 'Depreciation Taken' total. 

You will need to enter this amount when you report the sale in the 'Sale of Business Property' section, and Form 4797 is generated for you. 

In the Rental section, in Property Profile and Asset/Depreciation, you could report 'converted to personal use' and the date last rented (March 2022), if you haven't done that already. It actually could be reported on an Amended 2022 return, or you could use the date of 1/1/2023 to keep it in this tax year. 

You won't have any Rental Income in 2023 to apply QBI to.

If you end up with a Capital Loss, you'll be able to deduct at least 3K each year until it is used up. 

@NavyDavey2017 

[NavyDavey2017]

Thank you for the clear and comprehensive response.  This is very helpful.

Best regards,

David

[NavyDavey2017]

I have run into a challenge when entering the Sale of Business Property.  The application is saying that I can only enter a sale with a Gain in the "Sale if Business or Rental Property" section; not a sale that results in a loss.  I deleted it as a rental for any part of 2023, but am now stuck, not understanding how to reflect this as a sale of property purchased as a rental property. 

[DianeW777]

As sale of business property, it often leads to a loss and it is allowed to offset other income. The steps to enter your sale are shown below.  

If you removed the rental activity for 2023, it should have no affect on your Sale of Business or Rental Property.  Make sure you have the full amount of depreciation used on your tax returns prior to 2023 for your entry.  Since you are using this section to sell your rental property you should definitely separate land and building.  The gain would be handled differently if the land has a gain. Use the following example to arrive at the selling price for all assets.  You can include a combined amount for the house and improvements.  If there are any assets such as appliances, they should be entered separately from the house and the land.

Use the original cost of each asset listed on depreciation, 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. (Choices would also be fair market value on the date of the sale or adjusted basis on the date of the sale, which is cost less depreciation.)

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.

To record your sales in TurboTax Desktop follow the steps below:

1. Open your tax return 
2. Select the Business Tab > Business Income and Expense > I'll choose what I work on
3. Scroll to Less Common Business Situations > Sale of Business Property > Start or Update
4. Click Sales of business or rental property..... > Continue > Yes > 
5. Enter your sales information (leave the depreciation amount blank)

To record the sale in TurboTax Online follow the steps below:

1. Wages & Income at the top
2. Scroll down to Other Business Situations
3. Select Sale of Business Property
4. Select Sales of business or rental property that you haven't already reported.
5. Answer 'Yes' to Do all of the following apply...?
6. Enter your sales information, do not make an entry for depreciation (no zeros)
   1.  Description of the Property (Second Home/Previous Rental Home)
   2. Sales Price/Sales Expenses 
   3. Date acquired and date sold
   4. Sales Price
   5. Cost
   6. Depreciation

@NavyDavey2017 

[NavyDavey2017]

My version of TurboTax (Home and Business) does not have places to enter each of the items suggested separately (e.g., land, home, improvements).  It allows entries of Date Acquired, Date Sold, Gross Sales Price, Cost Basis and Depreciation taken.  I made related entries, and it generated a form 4797 and related entries in Schedule 1 and form 1040.  However, it shows a loss (negative additional income) on form 1040 of $-66,772.  I don't believe this is accurate, since I understood that capital losses are limited to $3,000 per year.  Am I mistaken about that?  If not, how do I get assistance in having TurboTax generate the correct entries on related forms?

[DianeW777]

Review your tax return and the entries you made. If you followed the steps above there can be more than one sale, however one sale should provide the correct results as well.. Once you verify the total loss to confirm your numbers it would be allowed to offset income. Only you can determine if the overall loss is correct and since you are unsure it's important to verify your entries.

If it's easier you can print your return to review before you file and make any necessary corrections.  

@NavyDavey2017