Sale of rental and capital gains with land value

[waiyin21]

Hi,

I purchased a rental property for 450,000 back in 2020.  Its been used 100% for rental. Land value is around 101k based on property tax bill. I made 45k in improvements before selling it for 500,000 in 2022.    

Based on what I understand  , the capital gains should be  500k - (450k + 45k ) = 5k.

I start by entering the info in "Rental Properties and Royalties (Sch E)"

Non at Real Estate Professional-> Add a Rental or Royalty

->Rental Property , Checked "Sold or disposed in 2022"

Start "Sale of Property/Depreciation"

-Yes for assets that can be depreciated

-Yes for improvements in 2022

-No for annual election.  Is this right to get my improvements into my purchase price?

Adding asset for improvement

-Add Asset ->   Rental Real Estate Property -> Appliances, carpet, furniture -> Appliance Replacement, 45000, date purchsed in 2022 -> Checked I purchased this asset,  checked "The Item was sold...", YES 100% of time for business. -> take full deduction this year.

Adding Asset for rental property itself.

-Add Asset->Rental Real Estate Property -> Residential Rental Real Estate -> Cost 450k,  Land 101k, purchased in 2020- >  Check "I purchased this asset", Checked "The Item was sold..", Entered Date sold in 2022, YES 100% , Entered date in 2020 for starting use. -> 19k in depreciation -> No Special handling ->  No for main home ->  Asset Sales Price 500k (based on 1099-S),  Land Sales Price 101k? ,  Lane Sales Expense 1049 (20%), Asset Sales Expense:  4196 (80%)

After all is entered, it calculates a gain of 166k.  It seems like the Land Value is taken out of the purchase price and the improvement wasnt considered.  Of all the videos ive seen on how to calculate gain for rental property sold, it was not done this way.  Am I entering all this incorrectly?

Thanks

[KrisD15]

When you sell rental property, there is almost always two types of income generated.  

Depreciation Recapture

Capital Gains 

Start "Sale of Property/Depreciation"

-Yes for assets that can be depreciated

-Yes for improvements in 2022

-No for annual election.  Is this right to get my improvements into my purchase price?

No, the rental and land needed to be entered when the rental was made available. 

If improvements were made prior to the rental becoming available, that cost would be added to the cost of the building and become the basis for the rental.

If improvements were made AFTER the rental became available, the assets and Improvements would be entered as separate assets when they were placed into service.

Everything starts depreciation when placed in service. 

Adding asset for improvement

-Add Asset ->   Rental Real Estate Property -> Appliances, carpet, furniture -> Appliance Replacement, 45000, date purchsed in 2022 -> Checked I purchased this asset,  checked "The Item was sold...", YES 100% of time for business. -> take full deduction this year.

No, you don't take full deductions for rental assets, it isn't allowed and it wouldn't do you any good regardless since Rentals are passive and you would not be allowed the deduction. Perhaps this is the "Missing 45,000" that is inflating your capital gain. 

If you added the assets as separate items, and it seems you did, be sure to allocate part of the selling proceeds to those assets to get them off the books. 

45,000 worth of appliances purchased just prior to the sale would get close to 45,000 of the sale, so that leaves 455,000 for the land and building.

That leaves 5,000 Capital Gains. This would be adjusted down for the expense of the sale. 

Since you sold for as much or more than what you purchased the property for, all depreciation needs to be recaptured, (whether you took the depreciation of not) 

You say there was 19,000, so you would have 19,000 Depreciation Recapture which is Ordinary Income. (as well as any depreciation on the appliances, which should be minimal.)

[Carl]

The first question that needs to be asked (yet wasn't) is, did you enter this rental property on your 2020 tax return when you purchased it and made it a rental?

[waiyin21]

Thanks for the response. Its really helpful!

I have some further questions prefaced with ">>>"

Adding asset for improvement

-Add Asset ->   Rental Real Estate Property -> Appliances, carpet, furniture -> Appliance Replacement, 45000, date purchsed in 2022 -> Checked I purchased this asset,  checked "The Item was sold...", YES 100% of time for business. -> take full deduction this year.

No, you don't take full deductions for rental assets, it isn't allowed and it wouldn't do you any good regardless since Rentals are passive and you would not be allowed the deduction. Perhaps this is the "Missing 45,000" that is inflating your capital gain. 

>>>   Sorry I thought  I checked "Item was sold".  With that I dont even get the option to take full deduction.  It  now ask for Sales Price and Sales Expense.    Lets assume the sales price is near 45k.  TWhat would I put down for the expenses?   Do I calculate what % 45000 is from the 450k (building) + 101k(land) + 45k(appliances), then I use that % to calculate the allocation from the closing cost?

Since you sold for as much or more than what you purchased the property for, all depreciation needs to be recaptured, (whether you took the depreciation of not) 

You say there was 19,000, so you would have 19,000 Depreciation Recapture which is Ordinary Income. (as well as any depreciation on the appliances, which should be minimal.)

>>> I actually didnt claim any depreciation for the past two years.  The expenses and property tax interest deductions were making me break almost even.   From what I read, I still need to repay the recapture.  If I didnt claim any depreciation, would it be alright to say 0?

[waiyin21]

@Carl Yes I did

[Carl]

@waiyin21 thanks for clarifying.

Since you did enter the property on the 2020 tax return and I assume continue to import it for the 2021 as well as 2022 return, are you sure you didn't take depreciation? I ask, because the program will usually (not always) automatically set that up for you in the assets/depreciation section in the Rental & Royalty Income (SCH E) part of the program.  If it did set it up in your case, the only way you could have not depreciated it, would be if you intentionally deleted or changed things in the assets/depreciation section.

Otherwise, when you enter the property and all assets, the program will "assume" you depreciated it by figuring the depreciation you "should" have taken in prior years, along with the current year (2022) depreciation based on your in-service date(s) for the assets. Since you're required to recapture depreciation  no matter what, leave what the program assumes and figures so it recaptures what you "should" have taken.

Below is the general guidance for reporting the sale.

Reporting the Sale of Rental Property

If you qualify for the "lived in 2 of last 5 years" capital gains exclusion, then when prompted you WILL indicate that this sale DOES INCLUDE the sale of your main home. For AD MIL personnel who don't qualify because of PCS orders, select this option anyway, because you "MIGHT" qualify for at last a partial exclusion.

Start working through Rental & Royalty Income (SCH E) "AS IF" you did not sell the property. One of the screens near the start will have a selection on it for "I sold or otherwise disposed of this property in  2021". Select it. After you select the "I sold or otherwise disposed of this property in 2021" you continue working it through "as if" you still own it. When you come to the summary screen you will enter all of your rental income and expenses, even if it's zero. Then you MUST work through the "Sale of Property/Depreciation" section. You must work through each individual asset one at a time to report its disposition (in your case, all your rental assets were sold).

Understand that if more than the property itself is listed in your assets list, then you need to allocate your sales price across all of your assets.  You will only allocate the structure sales price; you will NOT allocate the land sales price, since the land is not a depreciable asset.  Then if you sold this rental at a gain, you must show a gain on all assets, even if that gain is $1 on some assets. Likewise, if you sold at a loss then you must show a loss on all assets, even if that loss is $1 on some assets.

Basically, when working through an asset you select the option for "I stopped using this asset in 2021" and go from there. Note that you MUST do this for EACH AND EVERY asset listed.

When you finish working through everything listed in the assets section, if you ever at any time you owned this rental you claimed vehicle expenses, then you must also work through the vehicle section and show the disposition of the vehicle. Most likely, your vehicle disposition will be "removed for personal use", as I seriously doubt you sold your vehicle as a part of this rental sale.

[tagteam]

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@waiyin21 wrote:

....I actually didnt claim any depreciation for the past two years.  

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Since you did not claim any depreciation deductions for two consecutive tax years, you adopted an impermissible method of accounting, which can only be remediated by filing Form 3115 (and making a 481(a) adjustment).

See https://www.irs.gov/publications/p946#en_US_2022_publink1000107383

You may need to seek guidance from a tax professional, but it may be worth the time and expense depending upon the amount of tax liability you will incur from the unrecaptured Section 1250 gain (depreciation recapture).