How do I establish a cost basis for a rental property? I claimed a refinance deduction in 2014. Do I use information from 2014 or current information?

[ColeenD3]

Yes, there are two bases. 

When a personal residence is converted to business use (or for use in the production of income), its starting point for basis for depreciation is the lower of (1) the adjusted basis on the date of conversion, or (2) the property’s fair market value (FMV) at the time of conversion (Regs. Sec. 1.168(i)-4(b)).

Calculating Gain/Loss on Subsequent Sale of Rental Property

If a residence converted to rental property is later sold at a gain, the basis in the converted property is the original cost or other basis plus amounts paid for capital improvements, less any depreciation taken.

 If the sale results in a loss, however, the starting point for basis is the lower of the property’s adjusted cost basis or FMV when it was converted from personal.

[VTAX134]

I purchased a building for rental property several years ago.  At the time of purchase, I set it up  in Turbo Tax Home and Business on Sch E as rental property and entered the costs including closing costs, etc and date acquired for depreciation.  Several years later, I refinanced the building.  When I entered the refinancing, I set it up as an amortization intangible.  It is now depreciating that way.  I did not realize I did that.  It is no longer showing as the regular Non residential real estate, but as an amortization intangible?  The figures seem to be correct.  The amount of depreciation transferred from year to year correctly.  It just seems to be strange that the whole thing is categorized as an intangible?  In answering the questions, I did not realize it would be set up that way.  Anyway, now several years have passed since the refinance and I have sold the property and need to show the sale of the property.  I am wondering which options I should take to approach my taxes.

1.  Should I try to correct the classification and change it from an intangible to a nonresidential property? 

OR

2.  Should I correct the amount of the intangible so that it only shows the fees of the refinance, and then "add an asset "classified as an nonresidential property to show the actual cost of the building, less the refinance fees, and then do the cost basis and calculate the gain on it in the same section?  

I would appreciate any help and discussion on this subject as soon as possible.

Thanks!

[ThomasM125]

The way it should have been done was to enter the building as non-residential real estate, which would result in a 39 year depreciation period. Then, when you refinanced, fees associated with the refinance should be amortized separately over the remaining period of the loan. 

I think what you mean is you combined the original cost of the the building somehow with the finance costs and started amortizing the new basis over 39 years? If so, then your deduction would be about the right amount, but would appear as amortization expense on the tax return as opposed to depreciation expense.

The two are similar but not technically the same. If you got audited, you could amend the returns for the last three years but beyond that the IRS may disallow the amortization expense and not allow the associated depreciation since you didn't report it properly. 

For purposes of reporting the sale, you need to recognize the depreciation that should have been taken even if you didn't take it, but your asset basis in TurboTax would be close to what it should be, so when you report the sale your gain should be close to what it should be as well. 

The best solution would be to delete the asset and reenter it as two items, the building and finance fees. You amortize the finance fees over the term of the mortgage and the building gets depreciated based on what type of asset you designate it to be. When you enter the date put into service, TurboTax will calculate the prior and current year depreciation, so your sale will be properly recorded.

To amend the prior year returns would involve a lot of work, so if the depreciation expense was not material, it may be more work than you want to fool with, especially since the tax won't change much.

[VTAX134]

Thanks for responding so quickly.  I will make the change as you suggested by deleting the intangible asset for the building and will add it as a commercial property as it was before the refinance.  I will then add the refinance as one that is amortizable.  There still remains a problem though.  When we purchased the bldg, we made significant improvements the first year.  The problem is that one of my initial tenants was my business which occupied one of the spaces where we made significant improvements.  I did not claim any depreciation for the improvements on my personal taxes, but rather the business claimed them.  Should I include these improvements in my cost basis since it is treating it as if I depreciated it?  The selling price was based on the improvements.   Thanks for your help!

[VTAX134]

To clarify, I am asking if I should include the improvements in my basis in the sale of the property.

[VTAX134]

I am not sure if it is correct to add the improvement costs. It may cause an actual deduction for depreciation rather than simply provide information to correctly report the sale.  I am trying to make sure I am providing what is needed to correctly calculate the gain.  Still trying to make sure this is recorded properly.  I would appreciate any suggestions.

[ThomasM125]

I assume what you mean is your business paid for the improvements, and deducted at least a portion of them through expensing or depreciation.

What should have happened is you as landlord should have reported the improvements as rent income while you deducted the expenses through the business. Then, you could have added the improvements to the basis of the building and deducted them off the sale proceeds.

The improvements are an allowable deduction, but it seems they weren't reported properly. At this point in time, you may be able to argue that since you own both entities that you should be allowed to add the undepreciated improvements to the basis of the property, but that may not stand up to an audit. 

If you don't add the improvements to the basis, which is the safe thing to do at this point, you would not have to factor any depreciation recapture on them either, since they weren't added to the basis.

[VTAX134]

Thanks so much! You explained it perfectly.  I always try to correct any errors if I discover them, but trying to do that can sometimes create more errors.  Therefore my solution was to seek guidance first and it has been extremely valuable!

 This makes perfect sense.   I will not add the improvements although the cost may be legitimate.  I agree, the best way to correct the past in this case is to not add the improvements to the basis for the sale. 

It looked liked it was the best decision the more I pondered it last night, but I needed an expert opinion to be sure.  I wanted my records to be correct, but I also needed to be sure that my decision would not cause me to pay more in taxes than is required or in this case, necessary. 

Thanks again for such a timely response!😊

[MAC327]

Not sure if this is the best place to ask this question but I have been reading this thread and trying to understand how to correctly determine the cost basis for my garage conversion to an ADU and enter my information in to Turbo tax.

The information has been helpful but not specific enough for my situation.  We converted the garage to an to a 1 bedroom, bath kitchen ADU, my Mom is living there and paying rent to help with loan to build.

I purchased our house for 216,000 in 1997 - now valued at around 850,000.  We paid $91,000 in construction costs and furnished the apartment.  The Garage is 17% of the new square footage of both the house and new ADU. I'm not sure how to put this all together to get the correct cost basis. Any help would be great.

[AmyC]

Unless your mom is paying full rental value, you don't have a rental property to deduct.

See Publication 527, Residential Rental Property (Including Rental of Vacation Homes). page 18 for family limitations.

If mom is paying full rent, you want to depreciate that portion of your home.

The basis is the lower of FMV or your adjusted basis. Let's break this down.

FMV - fair market value of your home times17%

Cost basis - original purchase plus improvements so $307,000 times 17%

In your case, cost basis seems to be the lower number and will be your depreciation number if allowed to claim the rental.

@MAC327