Selling Rental - Cost Basis Issue

[Ryanvv126]

I'll just get right to the point. In 2006 my client purchased his principal residence for $400,000. Then, in 2008 he converted his primary residence to a rental property because he had to move to another state for work. The cost basis my client used was only $222,750 on his 2008 tax return (he did not have any improvements as the house he purchased was brand new). Finally, in 2016 he sold his rental for $325,000. 

As you can probably guess, this is causing my client to have a huge capital gain. Does anyone have any recommendations on how to appropriately adjust the basis since he recorded incorrectly in the first place? Thank you!

[Pacun]

I don't have time to do the calculations but this is what I think.

Cost 400K

Depreciation taken was about 1/3 of the 222,750 which is about 70K. So the house now cost him this:

400K - 70K equals 330 and he sold it for $325. I don't see a "huge capital gain".... as a matter of fact, I see a loss.

I have not even considered improvements or selling costs.

 

 

[jklcpa]

1 hour ago, Ryanvv126 said:

I'll just get right to the point. In 2006 my client purchased his principal residence for $400,000. Then, in 2008 he converted his primary residence to a rental property because he had to move to another state for work. The cost basis my client used was only $222,750 on his 2008 tax return (he did not have any improvements as the house he purchased was brand new). Finally, in 2016 he sold his rental for $325,000. 

As you can probably guess, this is causing my client to have a huge capital gain. Does anyone have any recommendations on how to appropriately adjust the basis since he recorded incorrectly in the first place? Thank you!

 

Do you know what the $222,750 represented at the time it was put on the depreciation schedule?  Was this after a salvage value or after land was broken out? 

[Ryanvv126]

2 hours ago, Pacun said:

I don't have time to do the calculations but this is what I think.

Cost 400K

Depreciation taken was about 1/3 of the 222,750 which is about 70K. So the house now cost him this:

400K - 70K equals 330 and he sold it for $325. I don't see a "huge capital gain".... as a matter of fact, I see a loss.

I have not even considered improvements or selling costs.

 

 

Thank you. You're number for depreciation is right on. I think I was confusing myself because I forgot to add back in the land that he allocated a lot to in the beginning. I guess allocating a lot to land actually helped him. 

[Ryanvv126]

2 hours ago, jklcpa said:

 

Do you know what the $222,750 represented at the time it was put on the depreciation schedule?  Was this after a salvage value or after land was broken out? 

It was after the land was broken out

[Pacun]

So, most likely you will have a loss. Is that loss deductible based on the fact that the house was a rental?

[jklcpa]

Ryan, be careful here with calculating a loss. Were you the preparer back in 2008 to know that the depreciable basis placed in service was the original cost after breaking out the land, or could it be that the FMV at the time of conversion to rental was less than original cost?  I'm asking because that 2008 time period was when the housing market had significant declines in value, and there might be other reasons for that smaller amount being used for depreciation.

When that happens and the property is subsequently sold, if that sale results in a loss using the full basis, you can't use the part of the loss attributable to the decline in value during the period it was used as a personal residence prior to conversion to rental status because a loss on a personal residence is never deductible.

This is an excellent and slightly older article from The Tax Advisor that you might want to review before finalizing that return, and even though it is an older article, the rules haven't changed. Pay particular attention to the caution at around the 4th or 5th paragraph, and the detailed discussion of calculating the gain or loss on these converted properties.  It also contains the reg. references to the pertinent sections that apply to this type of situation.

http://www.thetaxadviser.com/issues/2008/jul/convertingaresidencetorentalproperty.html

Edited March 4, 2017 by jklcpa
corrected name of the original poster

[Ryanvv126]

@jklcpaThank you so much. I'll have to see what the fair market value was on the day of conversion. That will be tough though. 

Like you said, what he had on his tax return in 2008 could be correct since that was when the housing market took a hit and his property was in AZ. From my understanding AZ took a big hit in 08. 

[michaelmars]

Not sure why the land is important to the calculation of g/l.  Pacon has it right.  Cost 400,000 [doesn't matter why the basis for depr  of 222,750 was picked]  Depr taken 70,000 leaving a basis of 330,000. Sold for 325,000. No gain.  The only issue open is if there is any part of the loss that is deductible.

[jklcpa]

I brought up the land initially because the original question asked how to fix what the original poster thought was the incorrect basis being used when it was first placed in service, so I asked if it was because the land was broken out. Then when he responded to Pacun, he said that he thought the difference from the depreciable basis compared to the original purchase was indeed due to the land. I got the distince impression that he seemed to think that it should be the full amount of the orginal basis (minus the land) in the property on the depreciation schedule, and that may not be the case if FMV was less, as we know.

[Max W]

R.E. prices peaked in the latter part of 2007, so if the house was purchased in 2006, it would have appreciated then declined. So, it is likely that the the FMV in 2008 was close to the purchase rice in 2006.  The decline began to accelerate after 2008 reaching bottom in 2011.

I had a client with a similar situation.  He purchased in 2008 and rented it in 2013.  By the time it was rented the market had rebounded substantially and the FMV was about the same as the purchase price.  

[Pacun]

I am an economist, so let's assume that jklcpa is correct and that the situation was this:

Purchase cost was 400K and when the house was converted to rental the FMV was $222,750 (structure and land). Let's assume that by mistake the preparer depreciated everything and didn't set money aside for the land. So now we are disposing the rental asset, we are going to take into considerations these items:

Original cost
add improvements
Basis:
Less depreciation allowed or allowable:
Adjusted basis:
Selling price:
Loss or gain.

Let's do it with numbers:

$400K original cost
0 improvements
$400K basis
70K of depreciation (even if it was not allowable, it was ALLOWED, so that number stands)
$330K Adjusted basis
$325K Selling price
$5K loss.

Keywords: Rent allowed or allowable. 

capisce?

 

[Pacun]

I meant to say:

Keywords on this issue at the time of sale are: Depreciation allowed or allowable.