Residential real estate - calculation of cost basis, depreciation and capital gains

Question

Background information: The purchase price of our new construction, detached, single family house (settlement in March, 2021) was $675K, including the lot. We added $25K of real property improvements. This house is not, and never has been, our primary residence. We are planning to engage a property management company to rent out the house, for the first time, starting on 8/1/2022 for 8-12 months, after which time we will sell this house.

I am confused about how to correctly account for the value of the lot when calculating 1) annual income taxes and 2) long term capital gains on the sale of the residential real estate.

Questions (hopefully, the right ones): Would the IRS consider this house a second home / vacation home or an investment property? When calculating our 2022 and 2023 income taxes, will the annual depreciation number for 2022 and 2023 be based on $700K ($675K + $25K) or on ($675K minus the value of the lot/land) + 25K? When calculating the long term capital gain when we sell the house in 2023, will the accumulated depreciation number be based on $700K ($675K + $25K) or on ($675K minus the value of the lot/land) + 25K?

Anonymous_ · Accepted Answer

The property will be considered a rental property (held for business use or the production of income) if you convert to rental use as you indicated.

Your basis for depreciation will be the lesser of the fair market value of the structure or the adjusted basis of the structure on the date of conversion.

Carl11_2 · Answer

The purchase price of our new construction, detached, single family house (settlement in March, 2021) was $675K, including the lot. We added $25K of real property improvements. This house is not, and never has been, our primary residence. We are planning to engage a property management company to rent out the house, for the first time, starting on 8/1/2022 for 8-12 months, after which time we will sell this house.

Since you have stated that the property will not be available for rent until 8/1/2022, the property is treated as a 2nd home until 7/31/2022. You convert it to residential rental real estate with an effective date of 8/1/2022.

I am confused about how to correctly account for the value of the lot when calculating 1) annual income taxes and 2) long term capital gains on the sale of the residential real estate.

What does the latest property tax assessment show? I would fully expect one to have been made once construction was complete. What this will show is the assessed "tax" value (not the FMV) of the property and they typically break down the value of the land and the value of the structure. What you're interested in, is what "percentage" of the tax value is allocated to the land. Then you will use that percentage to figure what percentage of your "actual" cost should be applied to the land.

Would the IRS consider this house a second home / vacation home or an investment property?

If you purchased this in 2021, then on your 2021 taxes it's treated as a 2nd home, since the property was not placed in service as a rental in the 2021 tax year. I am assuming you purchased it in 2021 and that contruction at least started in 2021. Weather construction was completed in 2021 or 2022 really doesn't matter.

When calculating our 2022 and 2023 income taxes, will the annual depreciation number for 2022 and 2023 be based on $700K ($675K + $25K) or on ($675K minus the value of the lot/land) + 25K?

Assuming the property tax appraiser appraised the property for tax purposes "before" the improvements were done, your structure value used for depreciation would be ($675K minus the value of the lot/land) + 25K on the assumption that the 25K of improvements were not land improvements, but were actual property improvements to the structure itself.

When calculating the long term capital gain when we sell the house in 2023, will the accumulated depreciation number be based on $700K ($675K + $25K) or on ($675K minus the value of the lot/land) + 25K?

Only the value of the structure and associated structure improvements are depreciated. Land is not a depreciable asset.

Finally, if you're using TurboTax for this, "you" really don't figure anything beyond the value of the land. The program does all that other stuff "for you" in the background and generally doesn't bother you with the details. Though I still recommend you print out the return before you file it so you can "check the numbers". When something doesn't "look right" or doesn't "add up' to whats expected, then 99% of the time it's user data entry error because the program did not clarify precisely enough the data needed, or the user did not read the small print on the screen.

Take note that depreciation does not start until the date the property is placed "in service". It's considered to be in service on the first day a renter "could" have moved in. Being that you've stated the property will not be rented before 8/1/2022, that indicates to me that your "in service" date will not be before that date.