Residential Rental Property Improvement and Sale in the Same Year

[johnjames9]

Hi,

I made material improvements to my residential rental property (spent $120K renovating it) and then I sold it for a gain in 2022. However, in my 2022 TT Home & Business, there is no option for me to enter the improvements made to the same rental property. Please can you help me with a step by step guide. Also, how do I determine the allocation of the sale price to Asset vs. Land? Can I just put all of it to the Asset and put nothing for the Land since all the improvements were made to the asset (residential rental building)? 

Also, I just realized that even if I add the improvement separately as an asset under the same property then it does not show up in form 4797 line 21 (cost basis). Please let me know your thoughts on how to fix this?

Thanks,

John

[Critter-3]

First all improvements or repairs made in the year of sale are simply entered on the schedule e as repairs. You cannot enter them as depreciable assets or take depreciation if you put them in service and take them out of service in the same tax year.

Next for the sale of the assets, you must allocate the sales price and the cost of sale to all of the assets you have listed in the depreciation worksheet. This includes the land that was not appreciated but should be listed as an asset. The program will not do this for you you will have to think back to third grade when they taught you how to do percentages and divide the the little number by the big number to get the ratio. For instance when you put the property into service, and you allocated the $100,000 of the purchase price as 80,000 to the building and $20,000 to the land ratio was 20% for the land and 80% for the building. You will use the same ratios for the sales price and cost of sale. If you have more assets listed on the depreciation worksheet then you need to total up the unadjusted cost basis of all of them and prorate the sales price and cost of sale by the same ratio of the cost basis of the asset to the total cost. 

[johnjames9]

I am not sure that you are correct. I believe I can just leave the land as the same amount as when it was entered into service as no improvements were made to the land.

Separately, please can you tax experts on here chime in on whether capital improvements made in the year of sale is all directly entered as a selling expense? My understanding is that even if there is any lag (as there was in this case since the repairs were completed by September 30th and the sale occurred on December 1st and the house was just vacant at that time) then that lag from repair completion date to sale today can be depreciated (in this case it was 2 months)?

[Vanessa A]

No, you cannot depreciate improvements made in 2022 on a property you held for only 2 more months and then sold.  @Critter-3 is correct.

Depreciation is taken over a number of years (27.5 years for residential real estate), not a couple of months.

[johnjames9]

Please can you confirm the following:

Details

• Bought the property on January 2, 2010 for $500K and at that time the land was $200K and the building was $300K according to the town property tax record. Hence, the building portion of $300K has been depreciating on a straight line basis (27.5 years) since 2010.
• The current accumulated depreciation is $10,909 x 12 years = $131K.  This depreciation will need to be recaptured. This is also the passive loss on this property as the rental income was offset by the property tax/interest/etc. Hence, due to income limitation rules, this $131K of depreciation kept building up as a passive loss each year and carried forward each year and could never be used.
• On 4/1/2022 the tenants left and we started repairs/improvements. The improvements were completed on 9/30/2022 and cost $120K. The house was listed for sale on 10/1/2022, went under contract on 10/31/2022 and was sold on 12/2/2022 for $700K. 
• The real estate cost (broker fee, real estate sale tax, title, legal, etc) to sell was $50K. 

Tax Treatment

• I will enter the sale price of the land as $200K. Hence, there is no gain or no loss on the land. In addition, there is no depreciation on the land.
• I will enter the sale price of the building as $500K. The gain on the building is: $500K - $131K (passive loss not allowed previously) + $131K (depreciation recapture) - $120K (2022 building capital improvements) - $50K (selling expenses) - $300K (original cost basis) = $30K gain.

Question for the Tax Experts

• Please confirm that my calculations above and thinking is correct. 
• Based on your earlier response, I will not enter the $120K 2022 capital improvement to the building as an asset and instead treat it as a "selling expense", correct?
• Please advise on the depreciation treatment and depreciation recapture treatment and nuances
• Please guide me as to how I should enter this in TurboTax as it looks like the program is not working for this as it should. 

[DianeW777]

Question for the Tax Experts

• Please confirm that my calculations above and thinking is correct.  
  • See my notes below under Tax Treatment.
• Based on your earlier response, I will not enter the $120K 2022 capital improvement to the building as an asset and instead treat it as a "selling expense", correct?
  • Yes, that is correct.

Tax Treatment

First I will place an example of how you prorate the selling price to each assets including the land.  

For any asset, such as appliances, that really have no value because they are past the recovery period of five years you can use a zero.

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. If you want you can check the allocation of building and land in your county real estate tax office, on file now.

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.

Passive Activity Loss Entry:

Assuming your passive losses were carried over each year, this will be a separate and identifiable entry which will carry to the Schedule E.  The full remainder of passive loss carryover is used in the year of sale as an expense. This is combined with your overall rental gain or loss to your Form 1040. 

• When you are on the screen 'Do any of these situations apply to this property?' (Property Profile section), be sure to check the box under Carryovers. 

• Please advise on the depreciation treatment and depreciation recapture treatment and nuances
  • See my notes below on entering the sales price/expenses for each asset inside the rental activity.
• Please guide me as to how I should enter this in TurboTax as it looks like the program is not working for this as it should.
  • See my notes below.

You need to dispose of the property by telling TurboTax how and when it was disposed of.  Follow the instructions below.

1. Click on Search (upper right) > type schedule e > Enter > click Jump to .... link
2. Answer the questions and on under Rent and Royalty Summary, click Edit
3. Click Update to the right of Assets/Depreciation.
4. Do you want to go directly to your asset summary?, click Yes and Continue
5. Click Edit to the right of each asset to be disposed of
6. Go through several screens until you get to Tell Us More About This Rental Asset
7. Click on This item was sold…….   And continue to answer the questions

You might also review information here.

[johnjames9]

Thank you - that was extremely helpful. A couple of final questions:

1. I am going to enter the 2022 capital improvements as "Repairs" in schedule E instead of "Selling Expenses" in form 4797 line 21. Please confirm that this is correct and that you agree? What difference does it make on the Taxes (if any)?

1. Is it a tax rule to "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"? My thinking was to just put the selling price of the Land equal to the cost basis so that there is no loss or gain as the Land was not depreciated and also should have no appreciation or gain/loss. Hence, all the gains and losses would be focused on the building. Is this not allowed and do I need to allocate the sales price and selling expenses to the ratio of the cost basis for the land/building that was originally entered when this asset was put in service by Tax law? I tried looking up the Tax law on this piece, but could not find anything concrete. 

[DianeW777 · Accepted solution]

No is the answer to your first question.  The improvements made in the year of the sale are not an expense although they are listed as such on the sale of the asset.  This must be part of the sale and not the rental income or loss.  The gain on the sale will apply capital gain favored treatment and the expenses used to reduce net rental income is handled differently on the tax return.  Do not enter it as repairs on the rental.

Allocation of selling price/selling expenses can be done in any reasonable method such as the current basis of assets (cost less depreciation) and total cost of land to arrive at the appropriate amount for each.  Likewise you could use a fair market value (FMV) of each asset to arrive at the appropriate percentage.  There are various examples in IRS Publication 544.  The 2022 version has not been released, however there has been little, if any, change for 2022.

• Example 

[johnjames9]

Thank you so much - it is very much appreciated. I am now very clear and all set.

[Michael_NC]

Hi Diane,

In John's situation, you indicate needs to treat his $120K improvements as a selling expense.

Assume that the $120K improvement were all made to the building structure asset.

So, would he first add the $120K to the other Sales Expenses to determine an overall Sales Expense total, and then use that figure to calculate the respective Sale Expenses for each asset?

Or would he use the initial Sales Expenses (sans the $120K amount) to determine initial Sales Expenses for each asset and then add the $120K amount to the calculated Sales Expense for the building structure since
the improvements were made specifically to the building?

Or does it matter as it seems that one would get the same total gain (profit) when summing all of the assets gains (profits)?

Thanks

[RobertB4444]

In your case you have said to assume that all of the improvements were to the structure so it would just be added to the structure.  But, as you also said, there is no difference in the bottom line here no matter how it is added so the key is to be able to explain the logic, if asked.  

@Michael_NC 

[hhschwind]

Hi,

I have been following this thread as I am in a similar situation.  I sold a rental property in 2022 that I had been renting out since 1996.  In 2022 I spent about $40,000 in renovations to the home (floors, repairs, appliances, etc.) and not the property just prior to listing it.

I can figure out how to allocate the net sales price between Asset and Land.  I just want to make sure I understand how and where to assign the $40,000 in renovations.  If I understand correctly, I do not add the improvements a "Property Asset" placed in service in 2022.  Rather, I consider it a selling expense (similar to a RE agent fee, closing fee, county tax, required pest inspection cost, etc.) thereby increasing my sales expenses and reducing my gain.

Is this correct.  Thanks.

[Critter-3]

The $40K of renovations are NOT added as an asset nor is it a cost of sale  ... it is put on the Sch E as repairs when they occur in the same tax year as the sale.

The sales price & cost of sale are prorated among the assets already listed on the depreciation worksheet. 

Ok ... a simple example of ratios ...  if you have more assets than the example then you will have more lines.  Remember if you divide a big number into a littler number you get a % ...  thus 5000/100,000 = 5%

       original  cost basis          ratios                  Sales price             cost of sale 

home    80000                   80%                          160,000               8,000

land       15000                   15%                           30,000                 1,500

roof        5000                        5%                           10,000                   500 

totals     100,000                100%                        200,000               10,000

All you need to enter into the program is the % of sales price & % of cost of sale for each asset being sold and you will have to do the math yourself as the program will not do it for you if you have more than one asset (the land & building are considered 2 assets) . 

And if you have NOT been taking depreciation as required  then RUN to a local tax pro when you file this return to get this error fixed correctly so you do not pay more taxes than you are required to do ... the form 3115 you need is not supported in the TT program and it is NOT a DIY project. 

[hhschwind]

Hi,

Thanks for your feedback.  I saw your previous response earlier in the thread.

I understand what you are saying.  However, it appears to conflict with the TT response that says, "The improvements made in the year of the sale are not an expense although they are listed as such on the sale of the asset.  This must be part of the sale and not the rental income or loss. "

I also understand that reporting the cost as a rental expense will reduce my taxable income which could result in bigger savings than reducing my capital gain.  Your advice conflicts with the TT advice, correct?

[Critter-3]

30+ years in the business and learned from those in it longer than I ... this is how I was always taught to do it and have done it without an IRS audit. But if you want to make it more complicated then that is your choice.