Solved: rental property cost basis
cancel
Showing results for 
Search instead for 
Did you mean: 
Highlighted
Level 2

rental property cost basis

My husband and I purchased a foreclosure late in 2015 for $220.5K and over a 3 year period we put about $40k into remodeling it to turn it into a rental in July of 2019.  My question is how to determine the cost basis of the property for depreciation for our 2019 taxes?  

I know we deduct the cost of the land (at the time of purchase?), from the total cost of the property (including improvements) to determine a cost basis, but how do we know what the fair market value was when we purchased it in 2015 since it was a foreclosure?  Also, do county assessed values at the time of purchase reflect a fair market value for the land?

Since it became a rental in July of 2019 do we use that year's FMV as our cost basis instead of the purchase price?  Confused!!

1 Best answer

Accepted Solutions
Highlighted
Level 15

rental property cost basis

First you need to know your cost basis, both now and when you sell.  Your cost basis is what you paid for the home plus what you paid for permanent improvements.  (You can't include the value of work you did, only money you paid for supplies or other people's labor.)

 

Then, the basis for depreciation is either the cost basis or the fair market value, whichever is lower, as of the date the property is placed in service, minus the value of the land.

 

If you think the land valuation is incorrect, you can get an appraisal from a local real estate professional.

 

The issue with depreciation and recapture is really complicated and there is no simple answer. You have to think about things like the concept of the present value of money.  Suppose you use a high land valuation, 40%, and you own the property for 20 years.  You will have deducted maybe $113,000 as depreciation.  Or suppose you use a low land valuation of 20%, you will have deducted $151,000.  Paying tax on $113K in the year you sell is easier on the wallet than paying recapture tax on $151K, but it's not that simple. 

 

Recapture is taxed at regular income tax rate but is capped at 25%.  Suppose you are in the 32% tax bracket now; the deduction saves you 32% now but will be repaid at 25% later.  Or suppose you are in the 22% bracket both now and when you sell, and you save 22% now and repay 22% later.  That sounds like a wash but its not, because for those 20 years, you will be able to use that money (about $1600 per year) for other useful things, like investing or buying more property.  Thanks to inflation, money you repay later is worth less than it is today even if the dollar amount is nominally the same.  (If you claimed $151,000 in depreciation over 20 years, you would save $1600 per year on your taxes, and owe $33,000 in recapture tax when you sell, at the 22% rate.  If you invested that $1600 per year in tax-free muni bonds at 3%, you would have a total of $45,000 from which to repay the $33,000.)

 

And if you were to die and leave the property to your children, they would receive a stepped up basis and not have to pay any recapture tax.

 

So there is an argument for taking as much depreciation as you can while you can.  I can't tell you which is better in your specific situation. 

*Answers are correct to the best of my ability but do not constitute legal or tax advice.*
**If a post answers your question, choose it by clicking on "Mark as Best Answer".**

View solution in original post

10 Replies
Highlighted
Level 15

rental property cost basis

since you acquired it by purchase and apparently never used as your personal residence or for some other purpose where the value to use would be the lower of FMV or cost,  FMV has nothing to do with the amount you use for depreciation purposes. You would use the $220.5 less the land value + the $40K for remodeling. 

if I'm wrong and you did use it for your residence or other personal purposes. then you would use the lower of FMV or cost on the date it became a rental property in July 2019

Highlighted
Level 2

rental property cost basis

Thank you Hackitoff,

You are correct, we didn't use the house for personal use as it was purchased with the intent to make it a rental property.  Thanks for clearing up the FMV issue as it relates to depreciation.  I do wonder however, about the land values reported by the county assessor.  Our land value is about 40% of RMV as evidenced by the property statement for the year purchased.  That seems excessive and also reduces the cost basis of the property...our loss!

Highlighted
Level 6

rental property cost basis

NEVER  under estimate the land value to increase the depreciation  since you will only have to recapture it later when you sell it  and that is taxed at a higher rate (in most cases) than the capital gains taxes ... you do yourself no favors in this matter.  So if the land values are 40% of the purchase price then use that percentage happily.  

Highlighted
Level 15

rental property cost basis

Our land value is about 40% of RMV as evidenced by the property statement for the year purchased.

I would kill for that kind of land to structure value. I try to keep my depreciation cost basis as low as a legally can. There are those who actually think depreciation is a permanent deduction. They learn otherwise the hard way in the year they sell the property.

Highlighted
Level 15

rental property cost basis

First you need to know your cost basis, both now and when you sell.  Your cost basis is what you paid for the home plus what you paid for permanent improvements.  (You can't include the value of work you did, only money you paid for supplies or other people's labor.)

 

Then, the basis for depreciation is either the cost basis or the fair market value, whichever is lower, as of the date the property is placed in service, minus the value of the land.

 

If you think the land valuation is incorrect, you can get an appraisal from a local real estate professional.

 

The issue with depreciation and recapture is really complicated and there is no simple answer. You have to think about things like the concept of the present value of money.  Suppose you use a high land valuation, 40%, and you own the property for 20 years.  You will have deducted maybe $113,000 as depreciation.  Or suppose you use a low land valuation of 20%, you will have deducted $151,000.  Paying tax on $113K in the year you sell is easier on the wallet than paying recapture tax on $151K, but it's not that simple. 

 

Recapture is taxed at regular income tax rate but is capped at 25%.  Suppose you are in the 32% tax bracket now; the deduction saves you 32% now but will be repaid at 25% later.  Or suppose you are in the 22% bracket both now and when you sell, and you save 22% now and repay 22% later.  That sounds like a wash but its not, because for those 20 years, you will be able to use that money (about $1600 per year) for other useful things, like investing or buying more property.  Thanks to inflation, money you repay later is worth less than it is today even if the dollar amount is nominally the same.  (If you claimed $151,000 in depreciation over 20 years, you would save $1600 per year on your taxes, and owe $33,000 in recapture tax when you sell, at the 22% rate.  If you invested that $1600 per year in tax-free muni bonds at 3%, you would have a total of $45,000 from which to repay the $33,000.)

 

And if you were to die and leave the property to your children, they would receive a stepped up basis and not have to pay any recapture tax.

 

So there is an argument for taking as much depreciation as you can while you can.  I can't tell you which is better in your specific situation. 

*Answers are correct to the best of my ability but do not constitute legal or tax advice.*
**If a post answers your question, choose it by clicking on "Mark as Best Answer".**

View solution in original post

Highlighted
Level 2

rental property cost basis

Thank you for your extensive answer to my question Champ.  So, if I'm understanding you correctly to determine the basis for depreciation,  I use either the purchase price of the property plus any improvements made or the FMV "as of the date the property is placed in service, minus the value of the land, whichever is lower".   

In this case, we purchased the property in 2015 as a foreclosure for $220.5K , most likely under market value.  We put about $40K in to the improvements and so have a cost basis of $260.5 K as of 2019 (the date placed in service.  According the county assessor, tdhe value of the land at purchase was 40% of the total RMV.  As of 2019 it has increased to 46% of RMV!!  Both percentages seem way off base, especially since our real estate market here has exploded and as of 2019 the RMV of the property has doubled.  Since the cost basis at purchase is much lower than the FMV at the date placed in service I am stuck with using that value.  What I'm wondering is am I obligated to use the county assessor's land valuation to determine the basis for depreciation?

Highlighted
Level 6

rental property cost basis

 What I'm wondering is am I obligated to use the county assessor's land valuation to determine the basis for depreciation?

 

No ... you can use any reasonable method to determine the cost of the land ... keep the records in case the IRS ever asks you to defend your position. 

Highlighted
Level 2

rental property cost basis

Thank you Critter,

I suppose you are right about not using an over inflated cost basis for depreciation, in the event we needed to sell the property we would be paying in more capital gains taxes.  However, we plan to use our rentals as retirement income, so don't plan on selling them anytime in the foreseeable future.  In this case we are hedging our bets that we won't encounter the aforementioned situation, but instead see the more immediate tax benefits on an annual basis.  

Highlighted
Level 6

rental property cost basis

This is why talking with a local tax professional and/or tax planner  is usually a good idea so you can make an educated decision  as  depreciation is one of those areas of the tax laws  where you can legally change the bottom line of the tax return depending on your goals/needs. 

Highlighted
Level 15

rental property cost basis


@nessanewf wrote:

Thank you for your extensive answer to my question Champ.  So, if I'm understanding you correctly to determine the basis for depreciation,  I use either the purchase price of the property plus any improvements made or the FMV "as of the date the property is placed in service, minus the value of the land, whichever is lower".   

In this case, we purchased the property in 2015 as a foreclosure for $220.5K , most likely under market value.  We put about $40K in to the improvements and so have a cost basis of $260.5 K as of 2019 (the date placed in service.  According the county assessor, tdhe value of the land at purchase was 40% of the total RMV.  As of 2019 it has increased to 46% of RMV!!  Both percentages seem way off base, especially since our real estate market here has exploded and as of 2019 the RMV of the property has doubled.  Since the cost basis at purchase is much lower than the FMV at the date placed in service I am stuck with using that value.  What I'm wondering is am I obligated to use the county assessor's land valuation to determine the basis for depreciation?


So your cost basis is $260,500.  That doesn't change.

 

As for the basis for depreciation, you may want to contact a local real estate professional.  Suppose the property in its current condition could sell for $280K; in that case your basis for depreciation will be $260.5 minus land value.  Or suppose the market has gone down and the best you could sell for today is $250.  Then your basis for depreciation will be 250 minus land even though you paid 260.

 

A local professional could give you a second opinion on the land value as well.  (It's not impossible, there's apparently a shack in San Francisco that sold for $1 million just so it could be torn down to build something newer.  In that case the land would be worth the $1 million regardless of what was built on top of it.)

 

In case of audit, the key is that your figure be "reasonable" and that you save your proof for as long as you own the property plus 6 years after you sell.  The best definition of "reasonable" is common sense.  The county assessment might or might not be reasonable, depending on how carefully the follow market movements and how often they perform reassessments. 

*Answers are correct to the best of my ability but do not constitute legal or tax advice.*
**If a post answers your question, choose it by clicking on "Mark as Best Answer".**
v
Privacy Settings