Forgot to Depreciate a Cap. Imp. Update Post #16

[Deleted]

MWCPA and other members of the TB,

As you may know from some of my other threads, DH and I are planning to return to the States next summer and move back into one of our former residences which we bought in 10/1996. One of the drivers for that decision is to take advantage of the up to $500k cap gains exclusions if one lives in the house for 2 of the last five years.

We were modeling some sales scenarios yesterday including one where we didn't move back in and did a direct sale to our tenants who have been living in the house since we moved out (8.5 years ago). When I started guesstimating our cap gains obligation, I realized that in the depreciation schedule we failed to list the addition, deck and rebuilding of our front entrance which was completed in 2001/2002. The total cost of that project was approximately $100k. Unfortunately my receipts for that project are in long term storage in the Phoenix area and are not easily accessible until we move back.

What's the easiest/most practical way to handle this situation? I don't really care about the fact that we haven't been able to take advantage of the depreciation over the 9 year period since we moved out. Our income has always exceeded the income limit for passive losses. Currently we have approximately $80k in carry forwards on this one house alone (basically all the depreciation) through 2010. Our total carrying forward is about $225k for all 5 properties through 2010.

I don't want to have to pay cap gains tax for this $100k improvement if we successfully negotiate a sale with our tenant. And I'm not inclined for file 9 amended tax returns because our current capital gain of approximately $250k (or $350 w/o listing the 2001/2002 improvement) is well below our $500k limit.

FWIW, I know I'm over simplifying the equation. I'm aware that even if we move back in, when we sell we're going to have to prorate our Cap gain with the 3.5 years (2009-6/2012) when the property was in rental service over our total years of ownership. And that we will also need to pay the special tax on recapturing depreciation. But for purposes of this thread I want to stay focused on the more fundamental issue of how to account for the capital expenditure in the event of a sale to our tenant.

Many thanks for your help and advice,

Bonnap

[mwcpa]

"One of the drivers for that decision is to take advantage of the up to $500k cap gains exclusions if one lives in the house for 2 of the last five years."

Be aware of the "non-qualified use" period related to the time the home was not your principal residence...glad you noted it at the end of your post, but for others who may not be aware...

from IRS publication 523

"Gain from the sale or exchange of the main home is not excludable from income if it is allocable to periods of nonqualified use. In most cases, nonqualified use means any period in 2009 or later where neither you nor your spouse (or your former spouse) used the property as a main home with certain exceptions "

So, a simple example.... bought a home one 1-1-2001, lived in it for 9 years (through 12-31-2010).... then on 1-1-2011 I rented it, until 12-31-11 and moved back in for another year until 12-31-12 when I sold it. Disregarding the need to report gain on the allowed or allowable depreciation for 2011, some of the gain below 250K (500K for a married couple) is subject to tax.... the non qualified period from 2009 forward is 1 year... total ownership is 12 years.... so 1/12 is the non qualified use.....

IRS publication 523 go through some examples....

Your issues

"Unfortunately my receipts for that project are in long term storage in the Phoenix area and are not easily accessible until we move back"

Under the law you need to be really careful.... it is up to you to prove the cost basis.... years ago I had a client audited related to his rental properties.... depreciation became an issue, the agent wanted copies of bills, etc for assets acquired 10+ years prior.... my client did not maintain them (even after I told him to).... deductions for depreciation disallowed....

if you sell the property in 2012 (and I assume you will be back in the US at that point) the "tax" (if any) is not due until April 2013, so you have time to get those documents from storage.

the basis of property used in business is the original cost less the depreciation that was allowed or allowable. In your case you need to focus on the allowable aspect. If you were supposed to claim depreciation and did not, the law treats it as if you did upon sale.

there are ways to correct this... look at form 3115 and it's instructions....

You can "correct" the depreciation that you did not claim by completing this form and filing it in accordance with the instructions...

This can be a little hairy, so you may want to seek the advise of a pro...

One final thought....

You note that you have 80K in passive loss carryovers....
If you sell the property (correct the depreciation, which would increase the passive loss carryover) the 80K of losses is "freed" up and is allowed to be deducted against other income.... now, that passive loss is "ordinary" income.... the gain on the sale is capital gain property and part will be subject to a maximum tax of 25% (related to depreciation) and the rest 15%....

So, let's day for argument sake you are in the 30% tax bracket (for ease) and the gain on sale if 270K (of which 50K is depreciation, I took your $250 and added the assumed depreciation fix therefore the passive loss carryover is now 100K)

You would report
Ordinary loss of 100K *.30 = (30,000)
Capital gain 50,000 subject to 25% tax rate (that does not mean it will be taxed at 25%, you need to do the computation) = 12,500
Capital gain 220,000 (270K overall less the 50K subject to the 25% rate) = 33,000

Overall tax 15,500.... not so bad on the gain of 270K....and how much cash will you net?

Also, I have not taken into effect any other planning that could be done....

You may want to review this with a local qualified tax professional....

[Deleted]

MWCPA,

Thanks so much for your quick response and the reference to form 3115. And thanks for running through a possible scenario.It's really interesting how you applied those numbers. I wasn't really sure when to start using up the carry forwards. We expect our income to drop to $80K in 2013.

A couple of comments/clarifications;

How did you calculate $50k as the amount subject to the 25% recapture? Shouldn't it be $100k if the carry forward for the property and the depreciation amounts are essentially the same number?

if we sell in 2012 our income will still be in the $250k-$300k range because of my husband's severance agreement with his company. Although we'll be bifurcating the income between Germany (7 months) and the US (5 months) I believe it is our overall world income which will dictate our final tax rate, correct? Therefore our tax rate is more likely to be in the 38% range right? Interesting that the "loss" becomes more valuable the higher the tax rate. And of course the property is located in CA and I think the top tax rate is at 9%.

Under the revised scenario I suspect that our tax burden is probably going to be a wash with a real estate commission in the $45k range. But in this market a bird in the hand...

It's really nice to know we have options. If our tenants do express interest and can provide reasonable evidence they can qualify for a loan we will pay a professional CPA to crunch the numbers.

Finally, we paid off the mortgage earlier this year so our net should be in the $650k range

[mwcpa]

"How did you calculate $50k as the amount subject to the 25% recapture"
I estimated that depreciation since the property was placed in service was 50K... it was merely for illustration purposes only, there is not enough facts to calculate what depreciation should have been....if you note my full post... "So, let's day for argument sake you are in the 30% tax bracket (for ease) and the gain on sale if 270K (of which 50K is depreciation, I took your $250 and added the assumed depreciation fix therefore the passive loss carryover is now 100K)".... the 50 is just a number I made up for an illustration purposes.... if your actual allowed/allowable depreciation was 100 and the actual passive loss carry over is 100, then the math for tax on the deal would be no more than...

Ordinary loss of 100K *.30 = (30,000)
Capital gain 100,000 subject to 25% tax rate (that does not mean it will be taxed at 25%, you need to do the computation) = 25,000
Capital gain 170,000 (270K overall less the 100K subject to the 25% rate) = 25,500

Total tax 20,500.... still not that bad..... you would walk away with $630ishK after tax....(I assume no prior 1231 losses in my computation, forgot to note that before)

And prepaying the Cali tax may provide a tax break at the federal level (unless you are in AMT).... one needs to run the numbers to see (that is something I am doing a lot of for my small business clients this time of year, planning for the cost of tax, among other matters related to year end financial matters)

[Deleted]

MWCPA,

Thanks for the clarification. Your other numbers were so close to what we were already calculating that the $50k just stuck out. And I reviewed the tax tables and see how you arriving at the 30% level. No 1231 property with this property.

Ordinary loss of $100k x .30 = -30,000

$750,000 gross sales price
- 480,000 initial acquisition and additional capital improvement costs (including forgotten $100k cap improvement)

$270,000 gross capital gain (we'll need to subtract county transfer tax and escrow)
-100,000 (capital gain subject to 25% rate)=$25,000

170,000 x .15% = $25,500

$20,500 Fed + 9% state tax, I'll just plug in 9% on the gross cap gains for now (24,300)= $44,800.

That has us netting quite a bit more, somewhere close to $700k. Wow!

[mwcpa]

you have your computation a bit wrong...

The initial price paid + improvements is reduced by depreciation that was allowed or allowable...

So, in this case, assuming depreciation that was claimed throughout the rental period was 100,000 then the gain is
Selling price 750,000

Basis is original purchase plus improvements of 480,000 less depreciation that was allowed or allowable of 100,000, or 380,000

The capital gain is now 370,000

The 370,000 capital gain is taxed as follows:
100,000 of the gain is taxed at a rate that may be 25% or 25,000
270,000 of the gain is taxed at a rate of 15% (assuming no prior 1231 losses) or 40,500

The prior passive losses of 100,000 are freed (assuming you are in the 30% federal tax bracket) (30,000)

California tax is on the "net" number of 370,000 gain less 100,000 prior passive losses allowed of 270,000 * 9% = 24,300

Total tax 59,800.

This does not factor in closing costs on the sale....

[Deleted]

MWCPA,

Thanks for going over the numbers again and catching my error

Closing costs on a private sale should be relatively minimal although the 1% county transfer tax comes to $7,500. Therefore net would be in the $680k range.

DH and I would really prefer to move back into the house and live there for the next five years or so. It's location is just about half-way between his mom in the Portland OR area and my dad in the San Diego area. Therefore only an hour's plane ride or a day's drive in either direction. But as I said in my original post our tenants will have lived in the house for 9 years. I know they really like the house and they have been very good tenants. Given how high rents are in the area (they have a sweet deal with us) they really should investigate buying rather than spending $3,500/mth in rent. It occurred to me that they might want to make us an offer rather than move. As we've worked through the numbers we keep coming back to it costing a little more to pay the tax than a real estate commission but it's a fair trade off given the uncertainty of today's real estate market. We know there's a lot amount of work to be done to prepare it for the open market place. In addition we'll probably spend more money on finishes and improvements which we won't recoup because we want to live in a house that is nicer than just 4 white walls and el cheapo carpet.

Thanks again for your help! <karma>

[rangerj]

Note that the depreciation that was allowed or allowable would not have been deductible due to the passive loss limitations, right? If that is correct then the amount of depreciation should be included in the amount of losses carried forward. The statute of limitations applies to the assessment and collection of tax and to refund so that neither you nor the government can go back into the old tax returns. However, both you and the government can correct the current year amount of carryforward from those old passive loss years. This carryforward becomes deductible, as an ordinary loss (generally), when the property is completely disposed of or sold.

[mwcpa]

that is correct ranger, at least by reading of the statute and regs.... and, as I noted earlier, the taxpayer can "correct" the missed depreciation by completing a form 3115.

[Deleted]

Ranger,

That is correct; we have always exceeded the income limits for passive loss activities since placing the house into rental service. Therefore, virtually all of the depreciation has been carried forward because up until earlier this year we had a mortgage and the positive cash flow was relatively modest after repairs and miscellaneous expenses.

So I guess the question is whether we file the 3115 for 2011 given that both this year and 2012 we will again exceed the passive income limits or wait until we actually sell the house. And if we don't sell the house until 2017 after we have moved into it and will have lived there for 5 years will we have passed the statute of limitations for filing the 3115?

ETA: My hesitation on filing the 3115 is that I won't have access to the 2001/2002 capital improvement until we get back to the States in August 2012. I generally keep excellent records and I know that the costs were in excess of $100k. But I suspect nothing triggers an audit like a nice fat round number like a $100k adjustment.

[Deleted]

BTW I want to thank you both for your help and patience as we puzzle out what to do. While we have tax professionals while we are in Germany, they are company paid and the client is the company. We can not contract with them separately to do any kind of planning or modeling.

[mwcpa]

you should file 3115 as soon as you can obtain the details.... it is best to file it with a tax return that includes the rental of the property.... and the entire 100,000 will not be the depreciation, I assume the property is residential and depreciation is over 27 1/2 years, so, assuming the addition was place in service on 1-1-02 you only missed 9 years of the 27 1/2 years of depreciation you are allowed, so you will not adjust depreciation and the passive loss carry over by 100,000 at the end of the day.... also, the deprecation you missed is claimed on the current tax filing that includes the 3115... so, if you correct things for 2011 you will show the back 9 years (in my example) of deprecation and the current year depreciation on the schedule E....

[Deleted]

MWCPA,

I understand that it's not the whole $100k but 9 years is roughly a third of that or approximately $33k of accumulated depreciation. I think I should wait until 2012 to have the 3115 filed when I have access to the records if it really doesn't make a difference. The property is leased through 7/31/12 and I'm not going to offer it for sale to our tenants (or give them notice of our return) until the end of January.

Thanks again for your patience and help,

Bonnap

[mwcpa]

2012 is probably okay to make the election.... but, we can only be sure of the law as of today, one never knows what act of insanity Congress make take up between now and 2012 when you return (chances are they do nothing and do more debating about pizza being a vegetable)

[Deleted]

"2012 is probably okay to make the election.... but, we can only be sure of the law as of today, one never knows what act of insanity Congress make take up between now and 2012 when you return (chances are they do nothing and do more debating about pizza being a vegetable)"

LOL <karma>

[TheOtherMe]

Nov 23, 2011 13:21:47 GMT -5 mwcpa said:

2012 is probably okay to make the election.... but, we can only be sure of the law as of today, one never knows what act of insanity Congress make take up between now and 2012 when you return (chances are they do nothing and do more debating about pizza being a vegetable)

;D

[Deleted]

Bumping for an update and a sanity check.

We wound up having to evict our long term tenants so no sale in 2012.

Our new plan is to live in the house for the next ten years and then sell and move into another rental. We'll be dumping over $100k into the fix up process. Although I know it's the "right" thing to do I'm wondering if it really makes sense to go through the brain damage to report the forgotten improvements (and yes I have access to my records).

So here are the revised facts;

Cap acquisition 10/95 $332k
Various improv & placed into rental service 6/2003 @ $365k (91k land val).
Forgotten $100k addition and remodel in 2000 in 2003 figure when placed into rental service in 2003.
Added another 16k in dep cap improvements during rental service.

Moved back into house 8/1/2012
Currently adding $100k+ in cap improvements.

Estimated market value of house after improvements (say June 2013) $850k

Given that our cap gain (including the forgotten improvements) is less than $250k if we use approx 60k in sales costs (7%) should we really care about getting the depreciation #s corrected? And if so why?

As mentioned in the original OP we've earned too much ordinary income and had to carry forward the losses on the house (mostly depreciation). At the end of 2011 our carry forward for this house was $21,263.

2012 will be the last "big income" year. We expect our income in 2013 will be around 85k ($75k from oil royalties and dividend income) and one last severance check for DH.

I'm estimating a net income for this property will be about $12.5k and depreciation of $6k (for the 7 months they still occupied the house). So we can use $6,500 of the $21,263 carry forward this year leaving approximately $15k in carry forward. I guess this can be used to partially offset the depreciation "recapture" we will have to claim when we sell. Looks like at the end of 2011 total accumulated depreciation for this property was $90,332. So in the year we sell we'll pay 25% fed tax on a net of about $80k depreciation, correct?

Thanks for taking the time to read through this post.

Bonny

[mwcpa]

you have gotten into a little more complicated area now.

www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Sale-of-Residence---Real-Estate-Tax-Tips
"On May 30, 1997, Amy bought a house. She moved in on that date and lived in it until May 31, 1999, when she moved out of the house and put it up for rent. The house was rented from June 1, 1999, to March 31, 2001. Amy moved back into the house on April 1, 2001, and lived there until she sold it on January 31, 2003. During the 5-year period ending on the date of the sale (February 1, 1998 - January 31, 2003), Amy owned and lived in the house for more than 2 years as shown in the table below. (table removed)
Amy can exclude gain up to $250,000. However, she cannot exclude the part of the gain equal to the depreciation she claimed for renting the house."

and there is a little provision of the tax law passed in the Bush years.....

www.irs.gov/publications/p523/ar02.html#en_US_2010_publink1000200713
"Gain from the sale or exchange of the main home is not excludable from income if it is allocable to periods of nonqualified use. Nonqualified use means any period in 2009 or later where neither you nor your spouse (or your former spouse) used the property as a main home, with certain exceptions (see next). "

read some of the "comprehensive examples" here... www.irs.gov/publications/p523/ar02.html#en_US_2010_publink1000200763
I think number 3 there may be useful.

Do not forget, in any computation of gain and loss the law requires that you reduce basis by depreciation that was allowed or allowable, not what you claimed.

[Deleted]

Hi MWCPA,

Thanks for your response. "you have gotten into a little more complicated area now." is the story of my life.

I'll need to re-read your post to make sure I understand what your are saying but I'd like some clarification on a term that's being used. 'Allocatable Gain. As everyone knows, most properties including mine went through a perfect Bell curve in value from 2003 through 2012. Meaning that at the time we put the property into service in August of 2003 the value was aproximately $750k. It soared to over $1M during the peak and then fell back to about $730k when we moved back into the house on 8/1/12. It's started climbing again and with the new improvements should be worth about $850k this summer. So in other words there was no net gain during the time the property was rented out. If I can document what I just stated is it possible that there is no 'allocatable gain" during the non qualified period or is it a straight mathematical formula based on # of years during the non qualified period vs # of years the property was owned?

Thanks,
Bonny

[mwcpa]

the gain is allocated on time....

I bought a home on 1-1-08.... rented it until 1-1-11 then lived in it as my principal residence until 1-1-18 the allocable gain for none qualified use would be

Rented time after 12-31-09... 1 year (1-1-10 to 12-31-10)... time before 1-1-10 does not count as non qualified or qualified.
Owned time 10... years.....

So 1/10th of the gain is not excludible.

It is strictly a time computation.

This is how some of the Bush cuts were paid for.

Non qualified use relates to a home that was rented (100%) or was a vacation home.

[Deleted]

Thanks MWCPA!