Rental Property Depreciation

[spqinbc2]

I own a rental condo which I have been depreciating in the last 9 years.  In 2020, I received as part of a group lawsuit from our plaintiff lawyer law firm a settlement of $100,000 for loss of value due to construction deficiencies.  The defendants number more than 30 involving private, public, developers, A/E, insurance companies, prime contractor and sub-contractors, etc.  Our law firm indicated there will be no 1099-Misc to be issued.

Question #1:  The settlement amount has to be reported to IRS in the 2020 tax return, even though there is no Form 1099-Misc?  Is the settlement amount taxable or non-taxable?

Question #2:  Do I have to adjust the "Depreciated cost basis (Initial cost basis - depreciation over the 9-year period) by the settlement amount ($100,000); and use the resulting cost basis to calculate the yearly depreciation over a period of 18.5 years (27.5 years - 9 years)?

Or:   Question No.3:  Just ignore Questions #1 and 2.  Adjust the initial cost base by the settlement amount when the condo is sought?

Responses are appreciated!

[M-MTax]

Get a local tax pro to look over the settlement docs.....but this does not sound taxable but more like compensation for a reduction in the cost basis because of the defect....so it affects your basis but should not be taxable. https://hoacpa.com/wp-content/uploads/2018/08/FAQ-What-are-some-accounting-and-tax-issues-related-to...

[DaveF1006 · Accepted solution]

It depends. If you receive compensation for a loss of value of your home and consequently a loss of basis, I opine that this is not taxable because you may pay more of a capital gains tax later because the basis of your property has been reduced by the reduction in cost basis. There is no economic benefit to you.  

Now how to handle the depreciated cost basis. This is a little tricky but this is the way I would do it. When you go to your asset summary screen in your program, you would reduce the cost basis by your $100,000 settlement amount. Let's use a scenario for illustrative purposes.

1. Original cost basis. $400,000. Depreciation over that period of time taken is $400,000/27.5=$14,545
2. Thus depreciation for a nine-year period is $14,545 x 9=$130,905
3. Next I would go to my asset summary page and select edit next to the property
4. I would scroll the next few screens until I reach a screen that says Tell us About This Rental Property.
5. Here I change the cost to $300,000 reflecting the loss of value. Leave the date of sale the same.
6. Scroll through the next screen and after that you should see a screen that says to confirm prior depreciation. Here I will enter $130,905. When you reach this screen, there will be a different amount. You can erase that record your prior depreciation amount.
7. Next screen will be your asset summary and you will see that the new depreciation expense for 2020, which is based from your new cost basis. Our scenario is based off of $300,000. When you get to your asset summary page, be sure to click on the box that says Show details. 
8. I will post an image that illustrates this scenario we have just seen at the end of this post.

Chances are this property will be fully depreciated before 27.5 years have expired but at least when you sell your property, but at least you will have an accurate amount of depreciation taken over the years.

Lastly, you may or may not receive a notice from IRS asking details about the change in cost basis. If so, you will reply back explaining the circumstances in the loss of basis. Also print a copy of this post, which relates to the advice you received from Dave, an esteemed Tax Expert that works for Turbo Tax. This is a situation that doesn't happen often but this is the position I would take and I stand by my decision. 

[Edited 01-27-2021|09:12 PST]