What cost basis to use when calculating an Asset's prorated sales price

[Michael_NC]

Hello,

In 2021, I purchased a short-term rental property and sold it in 2022.  In 2022, I made $24K in improvements (new HVAC, new windows) to the house 5 months before I sold the property.

I am trying to calculate the respective gross sales price for the house and land.

I understand that I need to determine the percentage of the cost of each asset.

That said, should I be using the original cost basis of the house and land when determining the respective percentages?

Or should I use the adjusted cost basis of the house (original basis + 24K for improvements) when determining the respective percentages?

Note: The only asset is the house and the land. I have not other depreciating assets.

Thanks in advance

[ThomasM125 · Accepted solution]

It would be best to use the original cost of the property for the percentage, since you are first dealing with the cost when your purchased it. The improvements came later on, so they shouldn't factor into the original cost percentages.

Also, since you didn't hold the house for long, it's not going to affect your taxes much either way, as your depreciation will be minimal so you won't have to deal much with the ordinary income factor the comes about from recapture of depreciation. 

[Carl]

Let's say you purchased the property for $100,000.  At that time you allocated 30% to the land. You have $70K for the structure and $30K for the land.

Next, you did $24K of property improvements to the structure.  That makes $94K for the structure and $30K for the land with a total cost basis of $124K now.

Now I'm assuming you sold the property at a gain. With two or more assets listed (the property itself, and the property improvements) your selling price on each asset needs to be "at least" $1 more than your cost basis in that asset. Otherwise, depreciation will not be recaptured and taxed correctly. The sales price of all assets should add up to your total sales price.  Here's an example using $200K as the sales price, but it's rough since this example doesn't actually show/account for recaptured depreciation.

Asset                   Cost                     Sales Price                  Sales Expenses                 Gain

Structure           $70000                 $120,000                        $7000                          $63,000

Land                   $30000                 $40,000                          $3000                          $7,000

HVAC                 $19,000                 $30,000                          $0                                $11,000

Windows            $5,000                   $10,000                         $0                                 $5,000

TOTALS             $124,000             $200,000                         $10,000                     $86,000

To that $86,000 gain you would add recaptured depreciation. But the program will tax that recaptured depreciation separately at the "ordinary" income tax rate.

If you show a gain on some assets and a loss on others, the program will incorrectly included the depreciation on those "loss" assets in the gain. That unrecaptured depreciation would then be taxed at the capital gains tax rate, instead of the ordinary tax rate.

Having owned the property a year, more or less, the depreciation isn't really going to be that much. But if your sale date is less than a year from your original purchase date you'll be taxed at the higher short term capital gains tax rate.

[Michael_NC]

Hi Carl,

Thank for your detailed example as it was very helpful. In reviewing it, I did have the following questions:

1) How did you compute the Sale Prices for each of the assets?

In reading your explanation, it appears that you selected Sales numbers that met the criteria where for each asset where the selling price on each asset is "at least" $1 more than the cost basis and the sales price of all assets adds up to total sales price as you explained?

So, other Sales Prices number could have been used in your example as long as the 2 criteria you explained are met?

2) For the Sale Expenses, it appears that you used the 70/30 cost basis allocation for the structure and land to calculate the respective Sales Expenses.  Because the HVAC and Windows were improvements, they would have no respective sales expenses correct?

3) Should the Gain number for the Structure be $43,000?

Sales Prices - Cost - Sales Expense + $120000 - $70000 - $7000 = $43000

Possibly a test to ensure I understand your example? 😉

4) It appears that I should have defined additional asset entries for the HVAC and Windows under the Sale of Property/Depreciation section?   Specifying the relevant information (e.g. Cost, Date or purchase, Date Sold, Sales Price etc) for each asset even though there will be no depreciation on them since I held them for less than 1 year.

Thanks for the education!

[Carl]

So, other Sales Prices number could have been used in your example as long as the 2 criteria you explained are met?

Yes. It doesn't matter the amount of capital gain I show on any specific asset. In the end, the capital gains total will be the same. I could have shown a $1 gain on the structure itself with a sales price of $77,001 and a sales price of $72,999 on the HVAC. That column still totals up to $200,000 and there's no change to the amount of recaptured depreciation correctly taxed at the ordinary tax rate.

For the Sale Expenses, it appears that you used the 70/30 cost basis allocation for the structure and land to calculate the respective Sales Expenses. Because the HVAC and Windows were improvements, they would have no respective sales expenses correct?

I used the same allocation of the sales expenses between structure and land, as I used for the cost basis between structure and land. Now I very well could have allocated some of those sales expenses to the other assets. But I'd have to be sure that when the program deducts those sales expenses from the sales price of that asset, I did not end up showing a loss on that asset.

even though there will be no depreciation on them since I held them for less than 1 year.

Understand that for that to "take effect", you would have to sell the asset in the same calendar year you acquired it, or put it in service. So if you acquired and put into service the HVAC in say, Sept of 2021 and sold the property in May of 2022, you have to claim/recapture depreciation since it crosses a calendar year.

It appears that I should have defined additional asset entries for the HVAC and Windows under the Sale of Property/Depreciation section?

If the assets were acquired in 2022 and sold in 2022, no need. If I recall correctly (I may be wrong here), somewhere in the process of reporting the sale, you have an opportunity to enter "increases/decreases in basis" so you can enter the cost of those assets that qualify for exemption from depreciation, and the program (not you) will add it to the cost basis.  In case I'm wrong, keep reading.

Basically, if the asset was acquired in 2022 and sold in 2022, there's no need to enter them in the assets/depreciation section. However, the program may not allow for a change in basis without doing so. If that's the case, and you did "in fact" acquire and sell the assets in the same tax year, then enter the asset in the Assets/Depreciation section with an "in service" date of the closing date of the sale. If any depreciation is taken for that one day, it'll be so minimal that it won't matter and you won't care.

[Michael_NC]

In my case, I acquired/put into service both the HVAC and Windows in Feb 2022 and sold them in Jun 2022. So, you confirmation about not needing to define addition asset entries is helpful.

I came across another TurboTax topic thread (Residential Rental Property Improvement and Sale in the Same Year)  that discussed handling home improvement expenses made in the same year that the rental property was sold. It was stated one could add the improvement costs to the house/structure Sales Expense.

Using your example, I applied this methodology using only the Structure and Land assets. I used the 70/30 ratio to calculate the respective Sales Price and Sales Expenses before rolling in the improvement costs to the structure Sales Expenses.

Using this approach, I arrived at the same total gain of $66,000 as in your example.
Note: There was a calculation typo in your example for the Structure where the gain is $43,000 not $63,000 and the total would then be $66,000

Asset               Cost                 Sales Price            Sales Expenses       Gain

Structure        $70000            $140,000              $31,000                   $39,000

Land                $30000           $60,000                $3000                       $27,000

TOTALS          $100000         $200,000              $34,000                   $66,000

I entered this sample information into Turbo tax and reviewed the resulting Form 4797.

Line 21. "Cost or other plus expense of sale" number for the structure was its original cost + sales expenses .

This seems like a logical approach to handling my home improvement expense treatment.

[Carl]

Since those two assets were placed in service and sold in the same tax year, it would be incorrect to depreciate them. They should not be entered into the assets/depreciation section at all. The only correct way to report this sale per IRS guidance is to convert the property to personal use with a conversion date of the closing date of the sale. Then, and only then, can you get the complete depreciation taken on the property and any other depreciated assets, up to the date of the sale.

Next, you report the sale in the "Sale of Business Property" section where you have to manually type in everything, including the total cost basis; which would of course include the cost of the two property improvements done in 2022.