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

[icnewer]

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. 

[AmeliesUncle · Accepted solution]

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@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?

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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.

[Mike9241 · Accepted solution]

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  

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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,

[Carl]

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.

[icnewer]

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 @Carl (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 · Accepted solution]

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.  

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

Results:

1. The amount of depreciation that was allowed will be completely taxable up to the amount of gain received on the sale.
2. 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
3. TurboTax will do all the calculations based on your entry

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

1. Scroll to Less Common Income > Select Sale of Home (revisit or update) 
2. Continue to indicate you sold your home > Edit or add your home address and ownership > Continue
3. Enter the Sales date, Selling Price and Sales Expenses > Continue
4. 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
5. Continue past the 'Less than two years' screen > Yes the home was not used for anything else > Enter number of days
6. Continue > Select No another home was sold after _____ date > Select ownership if married  > Continue
7. Select Yes for Depreciation After May 6, 1997 for both of you if married > Continue to answer the remaining questions

@icnewer 

[icnewer]

thank you, thought I got it but hopes to get it super clear on my understanding: 

1. "The amount of depreciation that was allowed will be completely taxable up to the amount of gain received on the sale" --> will this depreciation re-capture portion be taxed as ordinary income or investment gain rate?

2. "The remaining gain if any, will be split between taxable " --> naturally will this portion of "remaining gain if any" be taxed per investment gain rate?

Thanks again for your explanation & detail step-by-step guide.

[DianeW777 · Accepted solution]

A slightly higher rate than the regular capital gains rates. Any gain up to the amount of the depreciation used on the property will be taxed at a maximum 25% capital gains rate.  If your regular rate is lower it will be taxed at your regular rate.

• An unrecaptured section 1250 gain is an income tax provision designed to recapture the portion of a gain related to previously used depreciation allowances (25%).

Any gain on the sale that might exceed the amount of depreciation expensed before sale would fall into the regular capital gains tax rates. 2023 Rates:

A capital gains rate of 0% applies if your taxable income is less than or equal to:

• $44,625 for single and married filing separately;
• $89,250 for married filing jointly and qualifying surviving spouse; and
• $59,750 for head of household.

A capital gains rate of 15% applies if your taxable income is:

• more than $44,625 but less than or equal to $492,300 for single;
• more than $44,625 but less than or equal to $276,900 for married filing separately;
• more than $89,250 but less than or equal to $553,850 for married filing jointly and qualifying surviving spouse; and
• more than $59,750 but less than or equal to $523,050 for head of household.

However, a capital gains rate of 20% applies to the extent that your taxable income exceeds the thresholds set for the 15% capital gain rate.

There are a few other exceptions where capital gains may be taxed at rates greater than 20%:

1. The taxable part of a gain from selling section 1202 qualified small business stock is taxed at a maximum 28% rate.
2. Net capital gains from selling collectibles (such as coins or art) are taxed at a maximum 28% rate.
3. The portion of any unrecaptured section 1250 gain from selling section 1250 real property is taxed at a maximum 25% rate

@icnewer 

[icnewer]

thanks, it's a little complicated but I will have to play it out when I sell the home by using tax files to fully understand it clearly. 

[DianeW777]

You're not alone.  TurboTax will work it all out as long as you make the appropriate entries at the time of sale.  

Summary:

Difference between 25% and regular capital gains rates:

• Gain to the extent of depreciation will be taxed at your rate if lower but maximum of 25%
• Gain that exceeds the depreciation will be taxed at the capital gain tax rate regardless of your regular tax rate. 
  • Portions of the gain could be taxed at different rates depending on the amount of the gain that exceeds depreciation

@icnewer