Rental Sale with Improvements made both when being rented and and prior to sale

[earth777]

Hello - 

   I spent a few hours researching this but not able to find clear guidance.

1. Property was my home since 2008.  Moved out in June 2022, vacant for 9 months or so then converted to rental in 2023 and rented in Apr 2023
2. In Feb 2024, Improvement A ~15K was completed while tenant was living in house (upgraded carpet in master to hardwood, added external wall insulation, fixed a roof leak, replace water heater)
3. Tenant moved out in Sep 2024 as per our request to prepare for sale.   property was removed from the rental market
4.  Oct 2024 - Improvement B ~40K was completed to prep for sale then listed
5. Dec 2024 - Sold with a gain exceeding the exclusion allowance for main home

Question as to how to account for the above 2 improvements (below are some thoughts and would appreciate your input):

Improvement A - Since the hardwood flooring, water heater and wall insulation are all put into service same year as sale, i understand the IRS does not want them depreciated.  the improvements were done in Feb when the property was still a rental.  should i add them as additional assets (Option 1) in Sched E or expense them (Option 2)...   does Option 1 case TT to depreciate on mid-month basis? if so, this would be an issue.  [side question - when i dispose of them for a gain, will TT compute a short-term gain given < 12 months or will it default to the to the parent asset, the land or house and therefore compute a long-term gain].   Option 2 seems a bit odd to explain expensing flooring etc. which will reduce income vs capital gains that IRS will not like... i suppose for the water heater, since the cost < 2.5K, i can elect DMSH and expense it.

Improvement B - Since it was done after tenant left, i plan to convert the property to person use end of Sep thus removing from Sched E and adding the 40K to the cost basis, reducing my gain

thank you!

[pk]

@earth777  Having gone through your post and keeping in mind  the KISS ( Keep It Simple Stupid )  process:

(a)  On schedule-E for 2024  account for  any repairs that were done during  the tax year + applicable depreciation for the year.

(b) All improvements  whether expressly  under the  heading/purpose  of sale  or not are  just that " improvements .   These are all expensed as  Selling expenses  ( the logic  being  that improvements / repairs  just prior to sale are all " sales expenses" -- difficult to distinguish  those that increase the value  ( to be depreciated )  and those  for cosmetic reasons -- at least from a buyer perspective.  So I will put all improvements  and repairs  (after the renter's departure ) under the general sales expenses.

(c) Under sales  expenses  will also be items like title search/insurances , sales commission, transfer tax etc. etc.

(d) You  gain is then  Sales Price LESS Sales Expenses LESS adjusted basis  ( which is  Acquistion Cost + Cost of all improvements LESS accumulated   allowable depreciation ) LESS any suspended losses.  This gain/loss will flow  from 4797 , Schedule-D to form 1040

(e)  Your Schedule- E  will reconcile  rental income, expenses ( repairs, admin fees, taxes, mortgage interest etc. etc. ) and the net will flow to your form 1040 via schedule 1.

TurboTax will do all the work  and  fill the right forms for you.

 Does this make sense ?

Is there more I can do for you ?

[earth777]

thank you.  all make sense.  on (b), i am clear on improvements done prior to sale.   

the one area that is still not clear to me is how to deal with improvements that were done earlier in 2024 when the property had a tenant and improvements were done before any decision was made to sell later in the year.      If the property was not sold later in 2024, i would capitalize the improvements and depreciate/expense them per schedule on Shed E.   The issue is i ended up selling that same year and i understand that you are not allowed to capitalize (?) / depreciate assets (my early 2024 improvements) if they were sold in the same year.

another question - is it better to do the asset(s) sale in Sched E or inform Turbo tax that i converted to personal (even though i never lived in the property after tenant moved out, this will let me stop the depreciation on the move out date effectively moving the asset out of Sched E and then process the sale as a business)

[pk]

@earth777 

(1) If  you were to consider/ recognize the  first set of improvements  ( not the repairs )  by themselves  ( property   rented out  and improvements  without consideration of pending sale ),  then you  would have  depreciated these improvements  and thereby  increase your accumulated depreciation, resulting  in increased  income on Schedule-E,  reduced  basis and thus at the time of sale a higher  gain but more of the gain being treated as ordinary in com e ( not capital gain  tax rate ).  Therefore , and  since this was all within a reasonable  time period ( less than a year ), it  probably more tax advantageous  to include all the improvements  as part of  sales preparation expenses.

(2)  Note that when you sell this  rental/income property , you are selling as a business property  --- thus you use form 4797 and schedule D.    So I do not see  any advantage in terminating a rental property, recharacterizing as second home and then sell it  ---- at that point  it is not business  property.  The current  method is the one that allows use of business property benefits.  Once a property has been used for business / income, it is best to keep that characteristics.

(3)  Because this was your main home  then with a look back period of  five years  from the date of sale  conclusion/ consummation  ( closing ), you  would have to meet the  2 years of ownership and 730 days of  main residence use to  be eligible to exclude  any gain.

(4) Note that  from the gain, an amount equal to accumulated  depreciation ( whether taken or not)  will be taxed as ordinary income, the remainder  can be give Capital  gain tax treatment and/or excluded  up to  250K per filer meeting the   "main residence  use  "  clause.  That is another reason why you want to bin as little as you can in the depreciation category , if allowed by law.

Does this make sense ?

[earth777]

thank you ... make sense.  i wish the IRS had more guidance on this.. 

one thing that is clear is per Pub 946, Ch1 Pg 6,  "you cannot depreciate the property:  Property placed in service and disposed of in the same year"   in this context, i am assuming my first of improvements is placing "property" in service.

i am going to try to go with this suggestion... " Therefore , and  since this was all within a reasonable  time period ( less than a year ), it  probably more tax advantageous  to include all the improvements  as part of  sales preparation expenses."

[pk · Accepted solution]

@earth777 , the reason for not  being allowed to depreciate an asset that is put-in-service and disposed in the same calendar year  , is really because  once you dispose off the property is not in your hands  ( the new owner would start fresh depreciation schedule )  for more than a year.   General rule  for  requirement to depreciate  an asset is that it has to have a class life of more that one year ( and usually cost more than an amount -- usually 1000 ).  Therefore  my opinion to bundle all the improvements  that were done in the same year.

Is there more I can do for you ?

[earth777]

thank you.  much appreciate your help/guidance!