Better to claim a lower or higher cost basis on new rental?

Question

I just turned my former primary residence into a rental this year and it's going well. I'm trying to get all my ducks in a row for 2017 tax time. My question is what is the best approach for using my cost basis to claim on taxes going forward? The house was purchased by us in 2007 for $170K. It just appraised a year ago (refi) for $190K, which is close to the assessed value. I could justify $225K or so for a FMV with Zillow and other sites. Is it best to claim as little as possible or as much as possible in terms of depreciation (a function of the cost basis less land / 27.5 years)? Another question is if the recapture tax is still due if I 1031 down the road, or sell within a couple of years (using the living in 2 of the last 5 years rule, which I know may change with the Tax Reform act)?

If I have my head straight, claiming less depreciation now will result in a little more tax each year, but less recapture tax at a 25% rate when I sell. And just the opposite if I claim more depreciation. I estimate my tax bracket to be 15%, or 12% if the new laws pass, which may be the most important data point....

Thanks for your wisdom!

Brian

If I have my head straight, claiming less depreciation now will result in a little more tax each year, but less recapture tax at a 25% rate when I sell.  And just the opposite if I claim more depreciation.  I estimate my tax bracket to be 15%, or 12% if the new laws pass, which may be the most important data point....

Thanks for your wisdom!

Brian

Paul Allen · Answer

@Brian Ulrich probably best to claim the correct amount per the Internal Revenue Code - which is the lower of FMV or your adjusted basis. In your case it looks like adjusted basis wins.

You can delay the repayment of capital gains and depreciation recapture if you 1031 exchange the property down the road.

You cannot escape depreciation recapture by selling the house within the next 3 years, although you can escape the capital gains.

Welcome to BP! Best of Luck with Your Real Estate Investments!

Dave Toelkes · Answer

@Brian Ulrich,

Just a couple of comments.  Zillow is not accurate.  Don't rely on Zillow for your numbers.

If you think your property's value at the time you converted to a rental is greater than your actual cost basis, then you must use the lower cost basis for your tax basis and your depreciation basis.  The IRS does not give you a choice.  If you believe your current FMV is less than your actual cost basis, then best to have a formal appraisal to establish your tax and depreciation basis.  The thing to keep in mind here, you have to use the lower of FMV or actual basis for your new tax basis when you do the primary to rental conversion.  This means that when you sell your rental a few years down the road, your basis for capital gains calculations will be the tax basis you established at the time you converted to rental use.

If you sell down the road, the 2 of 5 year rule changes to a 5 of 8 yar rule for the section 121 capital gains exclusion under the proposed tax reform pending in Congress.  We don't know exactly what the final version of the tax bill will look like, but it will still need increased revenue to pay for the corporate tax rate reductions.

The depreciation recapture rate is not 25%.  Unrecaptured depreciation is taxed at your is your marginal tax bracket rate, but capped at 25%.  If you are in the 15% bracket, then your depreciation recapture rate will be 15%.

If you always 1031 and never have a taxable sale, you can defer the capital gains tax and the unrecaptured depreciation tax indefinitely.  Under the current tax code, these taxes are zeroed out when your heirs inherit your rental property.

Brian Ulrich · Answer

@Dave Toelkes

Thank you.  You got the specifics right.  For some reason, I was thinking that the purchase price from 10+ years ago ($137,700 for the dwelling) wouldn't apply to the cost basis I establish now that it's a rental.  Glad you set me straight on that one.  That could potentially result in a big tax bill for those who converted their primary residence to a rental after significant appreciation took place while they lived there.  In my case, it was very modest, only increasing $20K over 10 years.

Best,

Brian

Dave Toelkes · Answer

@Brian Ulrich

From your question, I assumed that you paid $170K for the property, including the land.   Since your actual purchase price for the property (including land) was $170,000, your 1-year old appraisal was $190,000, and your current tax assessment is $184,500, you MUST use the LOWER actual cost basis -- $170K -- to establish your tax basis for rental conversion.

You say that your tax assessor allocates 19% of your property value to the land.  This means that you paid $137,700 for the dwelling structure.   This is your actual cost basis for the dwelling structure and your depreciation basis as well.  The tax basis for the land which cannot be depreciated is $32,300.

Hope this clarifies my earlier response.

Brian Ulrich · Answer

@Dave Toelkes

Thanks for your insights.  Being a newbie landlord/investor, I'm honestly not sure which number to use for this first year, since there was no transaction to reference in terms of a purchase price.  The appraisal on the property (refi on the mortgage) came in 5-6 months before it was ready to rent, so that's pretty close.  I may just use that number after I factor out the land which I know I cannot depreciate (19% land, so that becomes $153,900).  I converted it to a rental April 1 of this year.  The county assessor valued the house itself (excluding land) for tax year 2018 at $149, 500, up from $133,400 in tax year 2017.  Based on this info and my understanding of IRS rules, I believe just using the $149,500 number is safe since it's a little less than than the FMV and it's easy to trace back if the auditors ever come knocking on the door.  Let me know if you disagree given my specifics.

I think I know why I was turned around on the 25% depreciation recapture rate.  It was because I read the "15% tax bracket Dave" scenario in this article on BP without the clarifier in the comments: section.  https://www.biggerpockets.com/renewsblog/2015/08/2... .  My long term goal is to 1031 or pass this rental along to my heirs to make some of this a moot point from a sale standpoint.

Thanks again,

Brian

Brian Ulrich · Answer

Thanks Paul Allen, that's exactly what I needed to know!

Better to claim a lower or higher cost basis on new rental?

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