Rental property conversion cost basis

[Retire6060]

I am converting my second home into a rental property. I made capital improvements leading up to the conversion.   My understanding is that the tax basis of the rental property is the lesser of the original cost or the value when it is placed in service, plus any improvements, less any depreciation taken.  If I made capital improvements of $35,000 before the conversion, would this amount be additive to the FMV cost basis of the property value when placed in service?  If the FMV is determined to be $250,000 at the time of conversion, would the $35,000 in improvements be additive to the FMV tax basis if  I sell in the future?

[tagteam]

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@Retire6060 wrote:

....If the FMV is determined to be $250,000 at the time of conversion, would the $35,000 in improvements be additive to the FMV tax basis if  I sell in the future?

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For the purposes of your depreciable basis, you would then use the FMV at the time of conversion inclusive of the cost of all previous improvements (unless your adjusted basis at the time of conversion is less than the FMV).

Your cost basis would, basically, be your purchase price plus the cost of any improvements. However, your (adjusted) basis would be reduced by the total of depreciation deductions that were taken (or should have been taken).

[Retire6060]

Thank you for your response. You indicate that the adjusted basis would be reduced by depreciation that otherwise would have been taken if the property had been a rental from the outset. With a 27.5-year life used for depreciation, if the home was owned for 13.75 years, depreciation of 50% of the cost basis would need to be deducted from the adjusted cost basis. Is that what you are saying?

[tagteam]

Yes, your adjusted basis (for purposes of the sale) would be the cost plus improvements less depreciation deductions (allowed or allowable).

[Retire6060]

Thank you.  I don't understand the tax fairness in deducting from the adjusted cost basis, depreciation that was never taken on the property before its conversion, and I would like clarification. You are saying that if a property had a cost of $200,000 and was held for 13.75 years before being converted to a rental property, and then was sold a year after the conversion,  the adjusted basis would be $100,000 (ex. capital improvements)  plus one more year depreciation (post-conversion)  even if the $100,000 depreciation deductions had never been taken (since it was a second home)?  Or are you saying that the one year of depreciation following the conversion to a rental property needs to be deducted against the adjusted cost basis only?

[tagteam]

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@Retire6060 wrote:

I don't understand the tax fairness in deducting from the adjusted cost basis, depreciation that was never taken on the property before its conversion......

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No, it is the depreciation deductions allowed (or allowable) during the time the property was used for rental purposes, not during the time it was not used for rental purposes.

[Carl]

Take what you paid for the property when you originally purchased it. Add to that the cost of the property improvements you have done during the time before you converted it to a rental.  Write that figure down.

Now look at the FMV of the property "today". Note that the FMV of the property today already includes the property improvements. Those improvements are not separate for this. Typically, you'd need an appraisal, but it's not required or necessary really.

You depreciate using the "lower" cost. Most likely, the lower cost is what you paid for the property originally, plus the cost of any and all property improvements you have done prior to converting it to a rental property.

[tagteam]

@Carl 

If you read the posts, you should notice that there were two issues raised; one for the depreciable basis and another for the basis used when the property is sold. 

Your post addresses one but not the other.

[Retire6060]

Thanks for your help. If I then sold the property after a year, and the real estate value has declined below the adjusted basis cost, is the loss deductible?

[Mike9241]

your basis for depreciation of the rental would be original cost + the costs of improvements made before conversion or FMV on date of conversion whichever is lower.   any subsequent improvements would also be depreciable.

when you sell your tax basis is your original cost + cost of all improvements less depreciation. as long as it was not converted back to a personal residence, any loss would be deductible