Depreciating a Cheap Renovated Buy-and-Hold Tax Sale Property

[Account Closed]

Newbie here and appreciate all the input and advice I've been passively soaking up.

I have a question about what tax benefits through depreciation are available to the real estate investor who purchases properties for very little money (under $10,000). Such a property would require extensive renovations and this is where I think I can make my start in REI as I'm very handy and industrious. So if the house sale price at a tax sale was $5,000 and I sink in $25,000 in actual renovations (sweat equity doesn't compute here), what am I entitled to depreciate on my taxes once it's all said and done?

It seems there could be three options: 1) depreciate only the purchase price of the home. 2) depreciate the purchase price of the property and the actual renovations. 3) depreciate the appraised value of the home after renovations.

I'm just looking for a general answer for what others have done. I'd be sure to ask my CPA at the appropriate time when it comes time to put numbers on tax forms. 

Thanks a million in advance!

[Brandon Hall]

@Account Closed

Great question. I'll tell you right off the bat that option 3 - appraised value will not be the case in your scenario. An example of when you would use Fair Market Value would be when you inherit a property or convert a primary residence to a rental. 

You will first need to determine your improvement ratio on the $5,000 purchase. Some of that $5,000 needs to be allocated to improvements, the remainder allocated to land. You cannot depreciate land. 

Second, until you place the property into service, the majority of expenses (especially capital improvements/repairs) will be added to the improvement cost basis of the property. 

Let's assume you purchase a property for $5,000 and determine that your improvement ratio is 85%. This means that of that $5,000, $4,250 is allocated to improvements and $750 is allocated to land. Let's say you make $25k in repairs and then place the property into service. Your new cost basis for depreciation will be $29,250 ($4,250 + $25,000). You will have annual depreciation expense of $1,064. 

Hope that helps!