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Solved

What's the right "cost basis" for a primary home converted into a rental home?

Forum|Forum|2 years ago
February 22, 2024
3 replies
0 views

Purchased a CA home 10yrs ago at 400k, then converted into rental home while its FMV is 700k already. What's the right "cost basis" in this case when calculate the depreciation? Should be original purchase 400k (+ any improvement cost and then minus land value as I know from IRS code) as the cost basis only as it's way lower than the FMV?

2nd question, if I moved back into this rental home in 5yrs later (converting it back to be primary home), and later selling it after living 2+yrs, do I need to pay that depreciation recapture tax and why? And will the cost basis choice (between FMV vs. original purchase value) impact this recapture tax please?

ps: saw a similar discussion there but not exact same thus I reposted it again and hopefully more experts like @DS30 can help further expand the topic.

Best answer by AmeliesUncle

@icnewer wrote:
What's the right "cost basis" in this case when calculate the depreciation? Should be original purchase 400k (+ any improvement cost and then minus land value as I know from IRS code) as the cost basis only as it's way lower than the FMV?

and later selling it after living 2+yrs, do I need to pay that depreciation recapture tax and why? And will the cost basis choice (between FMV vs. original purchase value) impact this recapture tax please?

You should have used 400k as the Basis for depreciation [the LOWER of (a) the Cost and (b) the Fair Market Value on the date of conversion to a rental].

Yes, the $250,000/$500,000 exclusion for your Principal Residence does not cover depreciation. It does not cover the GREATER of (a) the depreciation that you actually took or (b) the depreciation that you could have taken.

You also have "Nonqualified Use" for the rental period. That means that in addition to depreciation, a portion of the sale does NOT qualify for the $250,000/$500,000 Principal Residence exclusion.

AmeliesUncleAnswer

@icnewer wrote:
What's the right "cost basis" in this case when calculate the depreciation? Should be original purchase 400k (+ any improvement cost and then minus land value as I know from IRS code) as the cost basis only as it's way lower than the FMV?

and later selling it after living 2+yrs, do I need to pay that depreciation recapture tax and why? And will the cost basis choice (between FMV vs. original purchase value) impact this recapture tax please?

You should have used 400k as the Basis for depreciation [the LOWER of (a) the Cost and (b) the Fair Market Value on the date of conversion to a rental].

You also have "Nonqualified Use" for the rental period. That means that in addition to depreciation, a portion of the sale does NOT qualify for the $250,000/$500,000 Principal Residence exclusion.

Mike9241

400K plus improvements less the land value, when acquired, is depreciable (the lesser of cost or fair market value). depreciation recapture is always required when there is a gain on sale up to the amount of the gain. The code requires this. gain is figured as selling price less selling expenses less tax basis in the property.

Tax basis in the property is

the $400K(which includes the land) plus the cost of improvements less depreciation allowed or allowable.

so say you used it a a principal residence for 3 years

rented it for 5 years

then used it as a personal residence again for 7 years

thus total ownership 15 years

your home sale exclusion will be reduced because of nonqualified use (rental) irc Sec 121(b) (5)

period of nonqualified use 5 years

period of ownership 15 years

gain say $210K

gain not qualifying for home sale exclusion 5/15 X 210K or $70K

**************************

sec 121(b)

(5)Exclusion of gain allocated to nonqualified use
(A)In general
Subsection (a) shall not apply to so much of the gain from the sale or exchange of property as is allocated to periods of nonqualified use.

(B)Gain allocated to periods of nonqualified use
For purposes of subparagraph (A), gain shall be allocated to periods of nonqualified use based on the ratio which—
(i)the aggregate periods of nonqualified use during the period such property was owned by the taxpayer, bears to
(ii)the period such property was owned by the taxpayer.
(C)Period of nonqualified use
For purposes of this paragraph—
(i)In general
The term “period of nonqualified use” means any period (other than the portion of any period preceding January 1, 2009) during which the property is not used as the principal residence of the taxpayer or the taxpayer’s spouse or former spouse.

(ii)Exceptions
The term “period of nonqualified use” does not include—
(I)any portion of the 5-year period described in subsection (a) which is after the last date that such property is used as the principal residence of the taxpayer or the taxpayer’s spouse,

icnewerAuthor

Thanks @Mike9241 Mike, really appreciated your clear example.

Now I got the cost basis when calculation the rental basis: always LESSER one, as also pointed out by other experts of @AmeliesUncle and @Carl11_2 (thank you both too!)

follow-up question on that recapture: based on your listed example, for that 70k "gain not qualifying for home sale exclusion": we will have to include this 70k gain as the "investment income" into 1040 and pay the ordinary income tax for the sale year?

DianeW777

Yes, to the extent that depreciation was at or above $70,000 (total gain). Use the instructions below to enter your sale of home and have the total depreciation expense used when it was a rental. TurboTax will do the math and carry the gain to the appropriate sections of your return. Mike9241 gave a great example of how the sale will be handled.

When you enter the home sale in TurboTax it will ask for a couple of items that are needed to report the sale correctly.

The total depreciation expense that was allowed during the period it was available for rent. Check your prior tax returns for this figure.
The number of days the property was available for rent during the ownership period.

Results:

The amount of depreciation that was allowed will be completely taxable up to the amount of gain received on the sale.
The remaining gain if any, will be split between taxable and and amount eligible for exclusion by using the following formula.
- The total days available for rent will be divided by the total days owned to determine the portion of the remaining amount of gain that is taxable for the rental period
- The balance will be eligible for the home sale exclusion
TurboTax will do all the calculations based on your entry

Let's go step by step to enter your sale.

Scroll to Less Common Income > Select Sale of Home (revisit or update)
Continue to indicate you sold your home > Edit or add your home address and ownership > Continue
Enter the Sales date, Selling Price and Sales Expenses > Continue
Enter the Date Acquired and the Cost of the Home (includes any capital improvements for the period of ownership (do not reduce for depreciation expense) > Continue
Continue past the 'Less than two years' screen > Yes the home was not used for anything else > Enter number of days
Continue > Select No another home was sold after _____ date > Select ownership if married > Continue
Select Yes for Depreciation After May 6, 1997 for both of you if married > Continue to answer the remaining questions

@icnewer

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Carl11_2

Employee

Cost basis is the *LOWER* amount of:

1) What you paid for the property when you originally purchased it, plus the cost of any improvements you made *at* *any* *time* during your ownership, or;

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

It is not common for the FMV of the property to be the lesser amount.