Rental Property to Business Property to Sald Property

Question

We had a long term rental property. Tenant moved out at the end of Feb 2021. There were lots of damages and while investigating and fixing tenant caused issues, we found other structural issues not related to tenant actions. We did significant repair work and other improvements during the rest of 2021 and early 2022. Initially, we expected to fix it up and continue to rent it. We treated it as a rental for our 2021 filing and included a Sch-E form. We then decided we would need to sell it when done to cover repair costs. It was never rented in 2022 and sold in June 2022. We have prior year rental property losses that were carried over until there was profit to offset.

For sake of argument in the questions I ask below, lets assume:

- initial depreciable value of property was 150K -- it was classified as "I-Residential Rental" for depreciation purposes and 90K depreciation has been claimed

- prior improvement during rental occupancy of HVAC replacement cost 9000, was classified as "I-Residential Rental" for depreciation purposes and 3000 had been previously depreciated between in-service date and end of 2021.

- prior improvement during rental occupancy of whole house carpet cost 5000, was classified as "F-Rental Furnishings" for depreciation purposes and 4000 had been previously depreciated between in-service date and end of 2021.

- lets say there is 20K in carry-over losses on the rental property from prior years expenses that exceeded income in those aggregate years

- lets say the major repair costs totaled 100K which were paid out at various times in 2021 and 2022. None of this was treated as a rental expense or a capital improvement on 2021 taxes.

I'm trying to figure out my cost basis when sold, what I need to count for the 25% depreciation recapture tax and what portion, if any, of the remaining cost of the HVAC and carpet improvements not yet depreciated can be included in the cost basis of the property when it was sold.

1) Do I need to do a Sch-E for 2022 saying "1 day" with "$0 rent" so the form will be used in order to claim the remaining rental carry-over losses, or is there a different way to claim them, or are these lost to us at this time?

2) What portion of the HVAC and whole house carpet improvements gets added to the cost basis of the house? The full amount, the amount remaining after depreciation that has been taken or other?

3) Which depreciation items are covered by the 25% recapture tax when the property is sold? All of them or just the "Category I-Residential Rental" ones?

4) If the property is counted as an Investment Property, rather than Rental property, for 2022, can any of the 2022 carrying costs (mortgage interest, real estate tax, insurance, hoa fees) be counted in the cost basis to reduce the potential profit subject to capital gains taxes?

5) Which of these get counted in the total cost basis of the house?

- initial purchase price

- initial purchase closing costs

- portion, or all, of improvement costs made while a rental property

- carrying costs from 2022 when held as investment property or as non-rent generating rental property

- sales closing costs

Thanks,

David G

Carl11_2 · Answer

1) Do I need to do a Sch-E for 2022 saying "1 day" with "$0 rent" so the form will be used in order to claim the remaining rental carry-over losses, or is there a different way to claim them, or are these lost to us at this time?

You can do that if you want. That's what I would do. But even if you don't do that, you still get to utilize the PAL carry overs when you sell. You'll also still have to recapture depreciation.

As I see it, you'll still be filing SCH E for 2022 anyway, to show the conversion from rental property to personal use. (Personally, I'd leave it classified as a rental and not convert it) If you elect to do convert to personal use, then depreciation stops on the date you convert to personal use. (Jan 1 I presume). Also, you'll not be able to claim any rental expenses at all, that are incurred after that date of conversion.

2) What portion of the HVAC and whole house carpet improvements gets added to the cost basis of the house? The full amount, the amount remaining after depreciation that has been taken or other?

The program will take care of that for you. I.e.; cost basis and depreciation recapture. Depending on where you report the sale in the program, decides how the program will handle it. Either way you report it, the "bottom line" will be the same, presuming you enter the correct figures when prompted.

3) Which depreciation items are covered by the 25% recapture tax when the property is sold? All of them or just the "Category I-Residential Rental" ones?

The total of all depreciation taken is recaptured and taxed at the ordinary tax rate, which can be anywhere for 0% up to a maximum of 25%.

4) If the property is counted as an Investment Property, rather than Rental property, for 2022, can any of the 2022 carrying costs (mortgage interest, real estate tax, insurance, hoa fees) be counted in the cost basis to reduce the potential profit subject to capital gains taxes?

Rental property *is* investment property. But it's treated as "business property" and can (if you want) be reported in the "Sale of Business Property" section. However, if you convert the property to personal use, any expenses incurred "after" that date of conversion don't count for anything. Expenses incurred before you convert it to personal use, are rental expenses, not carrying costs or anything else.

5) Which of these get counted in the total cost basis of the house?

- initial purchase price

- initial purchase closing costs

- portion, or all, of improvement costs made while a rental property

- carrying costs from 2022 when held as investment property or as non-rent generating rental property

- sales closing costs

Initial/original purchase price, plus the cost of any property improvements you paid for while you owned it (The new HVAC for example, assuming you entered it as an asset in the tax year it was installed and placed in service), minus your sales expenses.

You do not subtract depreciation from your cost basis. The program will specifically ask you for depreciation and will take care of that "for you". How the program does it, depends on where you report the sale. Be it the Rental & Royalty Income (SCH E) section of the program, or the "Sale of Business Property" section of the program.

One thing that matters here, big time if you report the sale in the SCH E section of the program (which I would recommend, others may not). If you sold at a gain, you *must* show a gain on each asset. Doesn't matter if that gain is $1 on some assets, and $100,000 on other assets. A gain, is a gain, is a gain, is a....

If you show a gain on some assets and a loss on others, then the depreciation on those assets you show a loss on will not be recaptured and taxed correctly at the ordinary income tax rate. Instead, it will be included in the gain and taxed at the capital gains tax rate.