selling property with ADU- Do I need to pay depreciation on rental?

[DenyseRRussell]

We built an ADU in 2020. We rented it in 2021-2022. We then sold our property in 2023. We never claimed the money that it cost to build it, because that was in 2020 before we rented it. We have claimed improvments and maintenance for the 2 years we rented it through Turbo Tax. Was the ADU amortized in TUrbo Tax? Do I have to do sometnig special in filing taxes because I rented it? Or do I just file the capital gains for the sale of my house?

I only rented it for 2 years and owned the property for 5 years.

THanks for your help!

Denyse

[tagteam]

Technically, you were supposed to take depreciation deductions each year on the rental and, typically, you would need to recapture the amount that was allowed or allowable. 

You can, however, file Form 3115 (which is somewhat complex) to catch up on the foregone depreciation. 

I will page @AmeliesUncle for input on this scenario.

[AmeliesUncle]

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@DenyseRRussell wrote:

We built an ADU in 2020

Was the ADU amortized in TUrbo Tax?

Do I have to do sometnig special in filing taxes because I rented it? Or do I just file the capital gains for the sale of my house?

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Was the ADU a newly added portion of the building (or a separate building)?  Or did you just remodel the existing building (a portion that used to be your home)?

If you are not sure if you entered it, look in the rental section under "assets" or "depreciation".  You SHOULD have entered it there.  If you did not, then you may need to file Form 3115 to 'catch up' on the depreciation that you missed.  For Form 3115, I recommend going to a tax professional this year, one that is experienced with Form 3115.

You will probably be reporting it as TWO sales - one for your home and one for the ADU/rental.  You will need to divide the sales price between the two.  But that may depend on your answer to my first question above and the EXACT dates of the creation of the ADU and sales date.

[DenyseRRussell]

The ADU was a converted garage and a separate building. I figured out that it was 24% of the sqft of the whole house.  I did amortize it for 2021. And will amortize it for part of 2022. When I do my taxes next year for 2023  I will need to pay capital gains for the sale of my property. Do I need to pay money on 24% of the profit? Or since I only rented it for 1.5 years of the 4.5 years that I owned the property,  would I take ⅓ of the profit times 24% and claim that as income to pay tax on?

I stopped renting the ADU Nov 1, 2022 and sold Feb1, 2023.

Thanks

[AmeliesUncle · Accepted solution]

That's a difficult one.

If you merely rented out the garage - it would have been part of your personal residence for the last 2-out-of-five years, so it could all be covered under that.

If you had built a brand-new building - it would be completely separate and you would have paid tax on the gain due to that portion.

But you took a portion of your former residence/usage and remodeled it into a new "dwelling unit".  Looking at Regulation §1.121-1(e) and other things, I don't see any clear-cut answers.

To me, it would seem logical to assign the original garage/building as part of the original residence, and 'exclude' the gain from that.  But then all improvement cost consider as a separate property.  For example, if the original garage was $20,000 and you added $40,000 to convert it into a new ADU, I would think allocating 1/3 of that to the principal residence and 2/3 to a separate, taxable unit would be most logical.  But as I said, I'm not aware of anything clear-cut in that regard.

As side notes:  the 1.5 years over 4.5 years has no effect.  It is probably all-or-nothing, and is based on if it meets the 2 year rule (in your case, if the ADU was considered part of your personal residence/usage or not).  Also, I wouldn't assume your 24% based merely on square footage.  A separate building will usually have a different valuation, not merely based on total square footage.  I would get the house versus ADU appraised.  

[DenyseRRussell]

We remodeled a portion that used to be our home and added 288 sq ft.  we bought the home in 6/2018 and rented it in 1/2021. We sold in 2/2023. I it 2 separate sales?

I did depreicate it in Turbo Tax.  The cost was $240,000. We only rented it for 1 ½ years. Do I pay back the depreciation or am I taxed on the depreciation.  It was appraised at $180,000 by the city. Do I assign a percentage of the sale price, or use the $240,000 as the sale price? I wasnt renting it when we sold. There was a main house of 2250 sq ft, the ADU 700sq ft, a studio 280 sq ft , swimming pool and a big piece of property.  How do you find percentages for all that?

thanks, way over my head!

[AmeliesUncle · Accepted solution]

As I said, there is nothing clear-cut for your situation.

Personally, I think I would be aggressive and claim it all as your home, because at least PART of the garage (the non-addition part) was considered as part of your residence before it was converted to a rental.  But that is only what I would do; as far as I know, there is NO clear guidance for what to do in your situation.