Improvements to a rental property

[joewootan]

I read your Carl's input on this subject, great information. I have a similar situation.

I owned the home for 9 years, lived in it, made many additions/improvements, and then converted it to a rental for the next 22 years, sold it this year.

Can I include the things I did to the home prior to being a rental in the cost basis calculation ?

Thanks,

JW

[NCperson]

@joewootan yes, unless there are repeats. 

for example, let's say you replaced the roof 25 years ago and just did it again.  Only the most recent roof cost can be added to the cost basis. 

[tagteam]

You should have included any improvements made prior to the conversion to rental use in your basis for depreciation.

[Carl]

As I understand your post, you have a problem - and it's not a small one.

If these property improvements were done before the property was a rental, or while the property was a rental, they should have been included in the assets/depreciation section when you converted it, or when the improvement was placed in service. If you did not do that, then you have an issue with depreciation recapture.

Property improvements to rental property are supposed to be depreciated from the date they are placed in service. If you did not depreciate those assets, then when you sell the property you are still required to recapture "and pay tax on" the depreciation you "should" have taken. While taking depreciation may be an option, recapturing that depreciation upon sale of the property is not an option - it's required.

If your state also taxes personal income, then you've got a double-whammy here. You should seek professional help for this so it's done right. Doing it wrong can be significantly more costly than the cost of professional help.

No, you can't amend past returns to fix this. It requires IRS Form 3115 to be filed. While the TTX program does include the 3115, it is *not* simple by any stretch of the imagination. Therefore, you should seek professional help yesterday, if not sooner.

[joewootan]

I never added any of those previous improvements into my taxes. I added a 2 story addition, deck, and sunroom.

I always thought that was not anything I could use since I lived in the property when I made those improvements.

[joewootan]

Thanks for the advice.

[tagteam]

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@Carl wrote:

If these property improvements were done before the property was a rental, or while the property was a rental, they should have been included in the assets/depreciation section....

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The improvements were, apparently, made prior to the conversion, @Carl, so they would not be added separately in the assets section.

[tagteam]

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@joewootan wrote:

I always thought that was not anything I could use since I lived in the property when I made those improvements.

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You would add the cost of those improvements to your cost basis to arrive at your adjusted basis in the property.

Upon conversion to rental use, you would then compare that adjusted basis to the fair market value on the date of conversion and use the lesser figure as your basis for depreciation.

[joewootan]

Here's the long and short of it.

I lived in the home 9 years. During that time I added a 2 story addition, a deck, and another room.

I converted it to a rental, and it continued to be a rental for 22 years. I took my depreciation on my taxes including additional improvements throughout this period. I sold it this June for a profit. 

I was under the impression I take the FMV when it was converted to a rental for the sale on this years taxes. 

By using FMV the improvements are taken in consideration.

[tagteam]

You use the lesser of your adjusted basis or the fair market value on the date of conversion to rental use for the purposes of establishing your basis for depreciation.

You use your adjusted basis for the purposes of calculating your gain (or loss) on the sale of the property (note that your adjusted basis would include deductions for depreciation and the cost of improvements made during the 22-year period of rental use).

[Carl]

I took my depreciation on my taxes including additional improvements throughout this period.

Thanks for clarifying that.

I was under the impression I take the FMV when it was converted to a rental for the sale on this years taxes. 

No. Your cost basis is the *lessor* of

a. what you actually paid for it (including what you paid for improvements) or:

b. The FMV of the property on the date you converted it to a rental.

So if actual cost was the lessor was what you paid for it plus improvement costs (and it probably was since this was done around 2000-2002)  if you just report the sale in the Rental & Royalty (SCH E) section of the program, then the program (not you) will take all the numbers into account and do the math for you.

Otherwise, if the FMV was less than what you paid for it (which I doubt, but won't say it's not possible.) and that FMV was used for depreciation, then you can't report the sale in the SCH E section of the program. You report it in the Sale of Business Property section instead, so that you can use the "real" cost basis and still account for depreciation recapture.

[tagteam]

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@Carl wrote:

I was under the impression I take the FMV when it was converted to a rental for the sale on this years taxes. 

No. Your cost basis is the *lessor* of

a. what you actually paid for it (including what you paid for improvements) or:

b. The FMV of the property on the date you converted it to a rental.

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No, the above-quoted answer is not correct. 

Again, the basis for the purposes of the sale is the adjusted basis of the property.

The lesser of the cost basis (plus improvements) or the FMV of the property on the date of conversion is used strictly for the purposes of determining the basis for depreciation.

[Carl]

No, the above-quoted answer is not correct. 

That's because I didn't put it in proper context. So I understand why it would be wrong. Especially in this thread. To clarify:

Your cost basis *for depreciation* is the lesser of what you paid for it, or it's FMV at the time it was placed in service.

Your cost basis for the sale, is what you paid for it.

Some would call it your adjusted cost basis (and they would not be wrong), because you subtract depreciation from what you paid for it. However, entering that as your cost basis can have the potential for the numbers to come out wrong in the TTX program. That's because recaptured depreciation is taxed at the ordinary income tax rate, while the gain on the sale is taxed at the capital gains tax rate. So the program will ask you for depreciation separately, so it can correctly figure what gets taxed at what rate.