Rental property tax questions - determining cost basis

[hankscorpio84]

Hi all, this post may belong over in the real estate forum, but it is definitely a tax question, so I thought I would post it here.  I am an accidental landlord who is just figuring out some of the intricacies of real estate taxes and need to get some clarifications/advice to make an upcoming decision.  I have read through IRS publication 527 and still have some questions.

I built a house out of pocket in 2004 as an owner/builder and did not keep very good records of what I spent building the house. I did 90% of the work myself, so my best guess of true cost basis is around half of the tax assessment value ($220K).  I lived in the house until December 2013, when I moved and rented the house out.  This means I have until December 2016 to qualify for the 2/5 rule if I decide to sell.  I am leaning toward selling the house by December for several reasons, one of which is that I could claim the income as personal home capital gains - making up to $250K in gains tax exempt.  The only problem with this plan is that allowable depreciation must be recaptured at the time of sale.  I have not depreciated the property because I thought (incorrectly) that not claiming depreciation would avoid the recapture.   

If I were to keep the house as a rental, I would need to determine a cost basis for depreciation.  Publication 527 chapter 4 has a section called "basis of property changed to rental use".   This says:

"When you change property you held for personal use to rental use (for example, you rent your former home), the basis for depreciation will be the lesser of fair market value or adjusted basis on the date of conversion."

I know the adjusted basis would be lower than the FMV, but any number I come up with would still be a wild guess, without any receipts/documentation to back it up.  It seems that no matter which direction I go I need to determine a cost basis. If I sell, a lower cost basis would be the best, because the allowable depreciation would be lower.  If I continue to rent, a higher cost basis will allow me to claim more depreciation and save on taxes.  Either way, my ignorance has already cost me money, so advice/face punches on the topic are welcome and appreciated.  Any accountants out there who can offer any advice? 

[Drifterrider]

What profit do you think you can make (money in your pocket) if you sell it?

How long will it take you to make that much (money in your pocket) if you keep it as a rental?

[hankscorpio84]

I have no mortgage, so I would be receiving the total sale amount - I wouldn't take less than $215k. 

As a rental the house nets between $10-11k/year after all expenses, so ~20-25 years.  I would consider it a "class A" rental, low maintenance and good tenants so far, but as it ages costly repairs could come up and desirable tenants may go elsewhere.

FWIW I'm in the 28% income bracket.

[seattlecyclone]

Your true cost basis for the purpose of depreciating the rental would be the actual amount you spent to construct the house. Assessed value is irrelevant, especially if you put a lot of work into it yourself. You can't count that. Land costs don't count until you sell and want to compute your total gain on the property. Should have saved your receipts!

[seattlecyclone]

Practically speaking, you're just going to have to guess. Guess on the low side and you'll owe less tax. Guess on the high side and you'll have an easier time defending yourself in case of an audit. We're talking about three years of a 27.5 year depreciation cycle on a structure valued at roughly $100k. If you overestimate by even as much as $50k you'll only owe depreciation recapture on 3 / 27.5 * $50k = $5,454. Probably not going to break the bank.

[hankscorpio84]

Seattlecyclone - thanks for the response.  I plan to sell, guess high on the cost basis and take the slight tax hit now to wash my hands of it.  I'm currently saving receipts and using mint and credit cards to help organize my spending records so I won't have to guess next time.

[BlueLesPaul]

The only problem with this plan is that allowable depreciation must be recaptured at the time of sale.  I have not depreciated the property because I thought (incorrectly) that not claiming depreciation would avoid the recapture.   

I believe that you can still claim the allowable depreciation by filling form 3115.  If you don't/can't, you will have to pay tax on the recaptured portion without getting the tax benefit, basically the worst of both worlds.  I have never filed 3115 myself, but I hear it is quite complex, so you might want to discuss it with an accountant or a tax preparer that is familiar with rental property issues.

seattlecycle is right that you will need to calculate the adjusted basis, but I would try to recreate/validate the expenses as much as possible.  See if you can get bank statement, receipts would be better, but bank statements are better than nothing.

[Drifterrider]

Something I was thinking of but have been away from the computer.  You have three years to amend your tax return.  If you moved out in Dec 13 you probably didn't rent until Jan 14.  Go back and claim the depreciation.

Guesstimate your cost basis.  You know you can't depreciate land.  You know you can't depreciate your labor.  Therefore, you only need to calculate your materials and any subs' work that was done.

I'm sure you can find a free Google construction calculator that will help you make a materials list (and thereby come up with a reasonable number).  Failing that, have a realtor get you sold comps for your house (in the year it was built), then deduct the cost of land and labor.

[Vinivedivichi]

The purpose of this rule is to keep people from taking ordinary deductions (e.g. depreciation expense) at potentially/probably higher tax rates (e.g. 30% or so at the higher rates) and then realizing a LTCG when selling the asset at the more friendly 15/20% or so rate.  It sounds like you never took the deductions so by at least the intent of the rule you would not need to recapture since there is nothing to recapture.  I would not be inclined to recapture depreciation that I never got the benefit of.  As someone else mentioned, you could file a 3115 to claim the depreciation in retrospect, which is the safest route and actually could result in an overall benefit if your ordinary rate is higher than 25%.

[Drifterrider]

The purpose of this rule is to keep people from taking ordinary deductions (e.g. depreciation expense) at potentially/probably higher tax rates (e.g. 30% or so at the higher rates) and then realizing a LTCG when selling the asset at the more friendly 15/20% or so rate.  It sounds like you never took the deductions so by at least the intent of the rule you would not need to recapture since there is nothing to recapture.  I would not be inclined to recapture depreciation that I never got the benefit of.  As someone else mentioned, you could file a 3115 to claim the depreciation in retrospect, which is the safest route and actually could result in an overall benefit if your ordinary rate is higher than 25%.

Per the IRS rules, whether or not you take the allowable depreciation, you will be taxed for recapture.

[hankscorpio84]

Thanks to all for responding. I'll ask my accountant about form 3115. 

[BlueLesPaul]

Something I was thinking of but have been away from the computer.  You have three years to amend your tax return.  If you moved out in Dec 13 you probably didn't rent until Jan 14.  Go back and claim the depreciation.

Guesstimate your cost basis.  You know you can't depreciate land.  You know you can't depreciate your labor.  Therefore, you only need to calculate your materials and any subs' work that was done.

I'm sure you can find a free Google construction calculator that will help you make a materials list (and thereby come up with a reasonable number).  Failing that, have a realtor get you sold comps for your house (in the year it was built), then deduct the cost of land and labor.

I pulled this from IRS Publication 946, Page 14

Filing an Amended Return

You can file an amended return to correct the amount of depreciation claimed for any property in any of the following situations.
-You claimed the incorrect amount because of a mathematical error made in any year.
-You claimed the incorrect amount because of a posting error made in any year.
-You have not adopted a method of accounting for property placed in service by you in tax years ending after December 29, 2003.
-You claimed the incorrect amount on property placed in service by you in tax years ending before December 30, 2003.

Adoption of accounting method defined.
Generally, you adopt a method of accounting for depreciation by using a permissible method of determining depreciation when you file your first tax return, or by using the same impermissible method of determining depreciation in two or more consecutively filed tax returns.

For an exception to the 2-year rule, see Revenue Procedure 2015-14 on page 459 of Internal Revenue Bulletin 2015-5, available at www.irs.gov/irb/2015­5_IRB/ ar13.html.

For a safe harbor method of accounting to treat rotable spare parts as depreciable assets and procedures to obtain automatic consent to change to the safe harbor method of accounting, see Revenue Procedure 2007-48 on page 110 of Internal Revenue Bulletin 2007-29, available at www.irs.gov/irb/2007­29_IRB/ar13.html.
When to file.

If an amended return is allowed, you must file it by the later of the following.

-3 years from the date you filed your original return for the year in which you did not deduct the correct amount. A return filed before an unextended due date is considered filed on that due date.
-2 years from the time you paid your tax for that year

My reading is that if you have not claimed depreciation for two tax returns, you have to file 3115  unless you meet one of the exceptions, amending a return is not sufficient to remedy the issue.  Any CPAs or tax experts out there are free to correct me.